Off Balance Sheet Financing - Explained
What is Off Balance Sheet Financing?
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Table of ContentsWhat is Off-Balance Sheet Financing?How Does Off-Balance Sheet Financing Work?Enrons Off-Balance Sheet Financing Changes to Off-Balance Sheet Financing Rules
What is Off-Balance Sheet Financing?
Off-balance sheet financing is a strategy that keeps huge capital expenditures off the balance sheet of the company so as to lower down the debt-to-equity and leverage ratios. When a huge capital expenditure would affect negative debt agreements, this form of balancing is definitely considered. Some of the examples of off-balance sheet financing are research and development tie-ups, joint ventures, and operating lease agreements. Here, the asset lies on the balance sheet of the lessor, and the lessee informs alone about the rental expenses associated with using the asset.
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How Does Off-Balance Sheet Financing Work?
A company usually makes use of off-balance sheet financing when it is about to reach its borrowing limit, and has the necessity to buy or invest in an asset so as to reduce their interest rates on borrowing, or encourage effective risk management. This technique is application for arranging funds for different projects, subsidiaries, and the assets in which the company secures a minority claim. Generally Accepted Accounting Principles (GAAP) established rules and policies for firms in order to ascertain if a lease needs to be expensed or capitalized. Such rules became popular during the Enron bankruptcy when inaccurate off-balance sheet firms resulted in creating issues for energy traders. Besides GAAP, business entities should also consider following Securities and Exchange Commission (SEC), and prepare notes for the off-balance sheet financing in financial statements or company's books. These notes give investors an idea of prospective financial problems that the company may have, and allow them to decide whether they should invest in the company or not.
Enrons Off-Balance Sheet Financing
For the purpose of hiding huge debt loads, Enron considered using special purpose vehicle (SPV), a type of off-balance sheet financing. The firm used its cash and notes arising from SPV for trading its rapidly increasing stock. The special purpose vehicle (SPV) utilized stock so as to hedge assets recorded on the balance sheet of Enron. And with the reduction in the company's stock, the worth of special purpose vehicles also decreased and Enron was held liable for being in their favor. The company went bankrupt, and it was beyond Enrons reach to pay back its investors and creditors. Though the company mentioned about SPVs in the notes of the financial statements, most of the investors were not able to catch the intensity of the situation.
Changes to Off-Balance Sheet Financing Rules
The Financial Accounting Standards Board (FASB) that governs and regulates GAAP, brought changes in the rules for lease accounting that had a huge impact on the financial statements of retailers, telecommunication firms, hotels, restaurants, etc. This edition was made in February 2016. Generally, balance sheets don't have any records for lease agreements, and this makes it difficult for investors to assess the firms leasing activities and the potential of repaying to the creditors. Public firms that are located in the U.S. and are dealing with operating leases maintain more than $1 trillion in off-balance sheet financing for fulfilling their leasing obligations. However, as soon as the Accounting Standards Update 2016-02 ASC 842 comes into the picture, the concept of off-balance sheet financing will come to an end in 2019. Post off-balance sheet funding, the accountants will record the right-of-use assets and liabilities arising from leases in balance sheets. Also, there will be a requirement of making notes, and providing detailed disclosures in quantitative and qualitative statements. Furthermore, there will be no off-balance sheet financing for transactions related to leaseback and sale.