What is Off-Balance Sheet Financing (OBSF)?
Off-balance sheet (OBSF) financing is an accounting practice whereby companies record certain assets or liabilities in a way that prevents them from appearing on the balance sheet. It is used to keep debt-to-equity (D/E) and leverage ratios low, especially if the inclusion of a large expenditure would break negative debt covenants.
Understanding Off-Balance Sheet Financing (OBSF)
Companies sometimes take a creative approach when making big purchases. Those with mountains of debt will often do whatever it takes to ensure that their leverage ratios do not lead their agreements with lenders, otherwise known as covenants, to be breached.
They will also be mindful that a healthier looking balance sheet is likely to attract more investors and that banks tend to charge highly leveraged firms more to borrow money as they are considered more likely to default.
Examples of Off-Balance Sheet Financing (OBSF)
Operating leases has proved to be one of the most popular ways to overcome these issues. Rather than buying equipment outright, a company rents or leases it and then purchases it at a minimal price when the lease period ends. Choosing this option enabled a company to record only the rental cost for the equipment. Booking it as an operating expense on the income statement results in lower liabilities on its balance sheet.
Partnerships are another popular way to dress up balance sheets. When a company creates a partnership, it does not have to show the partnership’s liabilities on its balance sheet, even if it has a controlling interest in it.
- Off-balance sheet (OBSF) financing is an accounting practice whereby companies record certain assets or liabilities in a way that prevents them from appearing on the balance sheet.
- It is used to keep debt-to-equity (D/E) and leverage ratios low, facilitating cheaper borrowing and preventing covenants from being breached.
- Regulators have been seeking to clamp down on questionable off-balance sheet financing (OBSF).
- More stringent reporting rules have now been introduced to give more transparency to controversial operating leases.
Real World Example of Off-Balance Sheet Financing (OBSF)
Disgraced energy giant Enron used a form of off-balance sheet financing (OBSF) known as special purpose vehicles (SPVs) to hide its mountains of debt and toxic assets from investors and creditors. 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.
OBSF is controversial and has attracted closer regulatory scrutiny since it was exposed as a key strategy of the ill-fated energy giant Enron.
Off-Balance Sheet Financing (OBSF) Reporting Requirements
Companies must follow Securities and Exchange Commission (SEC) and generally accepted accounting principles (GAAP) requirements by disclosing off-balance sheet financing (OBSF) in the notes of its financial statements. Investors can study these notes and use them to decipher the depth of potential financial issues, although as the Enron case showed, this is not always as straightforward as it seems.
Over the years, regulators, eager to prevent a repeat of Enron’s naughty tactics, have been seeking to clamp down further on questionable off-balance sheet financing (OBSF).
In February 2016, the Financial Accounting Standards Board (FASB), the issuer of generally accepted accounting principles, changed the rules for lease accounting. It took action after establishing that public companies in the United States with operating leases carried over $1 trillion in off-balance sheet financing (OBSF) for leasing obligations. According to its findings, about 85% of leases were not reported on balance sheets, making it difficult for investors to determine companies' leasing activities and ability to repay their debts.
This off-balance sheet funding (OBSF) practice was targeted in 2019 when Accounting Standards Update 2016-02 ASC 842 came into effect. Right-of-use assets and liabilities resulting from leases are now to be recorded on balance sheets. According to the FASB: “A lessee is required to recognize assets and liabilities for leases with lease terms of more than 12 months.”
Enhanced disclosures in qualitative and quantitative reporting in footnotes of financial statements is also now required. Additionally, off-balance sheet financing (OBSF) for sale and leaseback transactions will not be available.
Regulators are seeking to make off-balance sheet financing (OBSF) more transparent. This will help investors, although it is likely that companies will still find ways to dress up their balance sheets in the future.
The key to identifying red flags in off-balance sheet financing (OBSF) is to read financial statements in full. Look out for key words such as partnerships, rental, or lease expenses and cast a critical eye over them.
Investors can also contact company management to clarify if off-balance sheet financing (OBSF) agreements are being used and to hopefully determine how much they really affect liabilities.