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 the use of the asset.
BREAKING DOWN Off-Balance Sheet Financing
Off-balance sheet financing may be used when a business is close to its borrowing limit and wants to make an asset purchase, 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.
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. Companies must follow 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 faced by Enron.
Enron's Off-Balance Sheet Financing
Enron used a form of off-balance sheet financing known as 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. When Enron's stock began falling, the values of the SPVs went down, and Enron was financially liable for supporting them. 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.
Changes to Off-Balance Sheet Financing Rules
In February 2016, the Financial Accounting Standards Board (FASB), which issues generally accepted accounting principles, changed the rules for lease accounting, which affects 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 thereafter 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.