Off-balance-sheet entities are assets or debts that do not appear on a company's balance sheet. Investors use balance sheets to understand a company's assets and liabilities and to evaluate its financial health. Because assets are better than liabilities, companies want to have more assets and fewer liabilities on their balance sheets. Some will place their obligations into off-balance-sheet entities.

Understanding Off-Balance-Sheet Entities

Off-balance-sheet entities allow companies to remove assets or debts from their balance sheets. For example, oil-drilling companies often establish off-balance-sheet subsidiaries as a way to finance oil exploration projects.

A parent company can set up a subsidiary and spin it off by selling a controlling interest (or the entire company) to investors. This sale would generate profits for the parent while transferring the potential risk of the new business failing to investors. Once this transaction is completed, the subsidiary no longer appears on the parent company's balance sheet.

The Dangers of Off-Balance-Sheet Entities

Off–balance-sheet entities can be used to artificially inflate profits and make companies appear to be more financially secure than they are.

A complex and confusing array of investment vehiclesincluding but not limited to collateralized debt obligations, subprime-mortgage securities, and credit default swapsare used to remove debt from corporate balance sheets. The parent company lists proceeds from the sale of these items as assets but does not list the financial obligations that come with them as liabilities.

For example, consider loans made by a bank. When issued, the loans are typically kept on the bank's books as an asset. If those loans are securitized and sold off as investments, the securitized debt (for which the bank is liable) is not kept on the bank's books.

This accounting maneuver helps the issuing firm's stock price and artificially inflates profits, enabling CEOs to claim credit for a solid balance sheet and reap huge bonuses for them.

A History of Fraud

The Enron scandal was one of the first developments to bring the use of off-balance-sheet entities to public attention.

In Enron's case, the company would build an asset such as a power plant and immediately claim the projected profit on its books even though it hadn't made one dime from it. If the revenue from the power plant was less than the projected amount, instead of taking the loss, the company would transfer these assets to an off-the-books corporation, where the loss would go unreported.

The entire banking industry participated in the same practice, often through the use of credit default swaps (CDS). The practice was so common that just 10 years after JPMorgan's 1997 introduction of the CDS, it grew to an estimated $45 trillion business, according to the International Swaps and Derivatives Association.

That's more than twice the size of the U.S. stock market, but it was only the beginning. The CDS market would later be reported to be worth in excess of $60 trillion.

The use of leverage further complicates the subject of off-balance-sheet entities. Consider a bank that has $1,000 to invest. This amount could be invested in 10 shares of a stock that sells for $100 per share. Or the bank could invest the $1,000 in five options contracts that would give it control over 500 shares instead of just 10. This practice would work out quite favorably if the stock price rises, and quite disastrously if the price falls.

Now, apply this situation to banks during the credit crisis and their use of CDS instruments, keeping in mind that some firms had leverage ratios of 30-to-1.

When their bets went bad, American taxpayers had to step in to bail the firms out in order to keep them from failing. The financial gurus who orchestrated the failures kept their profits.

The Future of Off-Balance-Sheet Entities

An attempt to limit the use of off-balance-sheet entities was incorporated into the Sarbanes-Oxley Act, which decreed that public companies have an obligation to provide proof of the accuracy of their financial reporting in their annual audits.

As part of that law, public companies have since 2003 been required to report all off-balance-sheet arrangements in their quarterly and annual financial reports to the Securities and Exchange Commission (SEC).

Efforts to change accounting rules and pass legislation to limit the use of off-balance-sheet entities do not change the fact that companies still want to show more assets and fewer liabilities on their balance sheets.

With this in mind, they continue to find ways around the rules. Legislation may reduce the number of entities that don't appear on balance sheets but loopholes will continue to remain firmly in place.