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.

RELATED TERMS
  1. Off-Balance Sheet (OBS)

    Off-balance sheet is the classification of an asset or debt that ...
  2. Aggressive Accounting

    Aggressive accounting refers to accounting practices designed ...
  3. Enron

    Enron was a U.S. energy-trading and utilities company that perpetuated ...
  4. Operating Lease

    An operating lease is a contract that permits use of an asset ...
  5. Bargain Renewal Option

    Bargain renewal option is a clause in a lease agreement that ...
  6. Special Purpose Vehicle/Entity ...

    A special purpose vehicle/entity - SPV/SPE is a "bankruptcy-remote ...
Related Articles
  1. Investing

    Uncovering Hidden Debt

    Understand how financing through operating leases, synthetic leases, and securitizations affects companies' image of performance.
  2. Investing

    Off-Balance-Sheet Entities: An Introduction

    The theory and practice of these entities varies greatly. Investors need to learn what they're getting into.
  3. Small Business

    The basics of financing a business

    From debt financing to equity financing, there are numerous ways to fund a business startup. Find out which one is the best funding model for your company?
  4. Investing

    Evaluating a Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  5. Investing

    American Airlines’ 3 Key Financial Ratios (AAL)

    Learn about the financial ratios that are important in understanding and evaluating the business and financial statements of American Airlines Group.
  6. Investing

    8 Stocks That Are Crushing the S&P 500

    Our second story on healthy balance sheet stocks looks at health care, energy and cosmetics cos.
  7. Investing

    Top 8 Ways Companies Cook the Books

    Find out more about the fraudulent accounting methods some companies use to fool investors.
  8. Investing

    An Introduction To The Balance Sheet

    The balance sheet is a basic accounting tool used by individuals, business owners and even large corporations to track net worth. Discover its main components and how they work together.
RELATED FAQS
  1. Does the balance sheet always balance?

    Yes, a balance sheet should always balance. The name "balance sheet" is based on the fact that total assets will equal the ... Read Answer >>
  2. How do the balance sheet and cash flow statement differ?

    The balance sheet and cash flow statement are financial statements that companies issue to report their financial performance ... Read Answer >>
  3. On which financial statements does a company report its long-term debt?

    Discover which financial statements are used to report a company’s long-term debt, as well as how a company uses debt to ... Read Answer >>
  4. What debt/equity ratio is common for companies in the telecommunications sector?

    Learn the average debt-to-equity ratio for the telecommunications sector and how including operating leases can substantially ... Read Answer >>
Hot Definitions
  1. Business Cycle

    The business cycle describes the rise and fall in production output of goods and services in an economy. Business cycles ...
  2. Futures Contract

    An agreement to buy or sell the underlying commodity or asset at a specific price at a future date.
  3. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  4. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  5. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  6. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
Trading Center