Definition

The definition of off-balance-sheet is nearly literal. It does not appear on the balance sheet of a
company's financial statements. Off-balance sheet financing is a legitimate, permissible accounting
method recognized by Generally Accepted Accounting Principles, or GAAP, as long as GAAP
classification methods are followed. This form of financing is nearly always debt financing, so the
debt does not appear as a liability on the balance sheet.

Off balance sheet financing is a financial obligation of a business that is not stated on its balance
sheet. These arrangements are used when an entity wants to keep its leverage ratios as low as
possible, possibly to avoid breaching a loan covenant that forbids a high degree of leverage. Also, by
presenting a low debt level to lenders, borrowers can obtain a lower interest rate on their debt
arrangements.

The use of off balance sheet financing is not encouraged, since it makes for obscure financial
statements that do not reflect an entity's true condition. Investors may be surprised at a later date
when the circumstances change or there are alterations to the accounting standards, resulting in the
sudden appearance of large amounts of debt on an organization's balance sheet.

Goal

The goal of off-balance sheet financing is to reduce or maintain a company's debt at at or below a
prescribed level so that its debt-to-equity ratio is low. When a company has a favorable ratio, that
company appears to be a good credit risk. In addition, a company may have other debt, including
bank loans or bonds that requires the company to maintain a minimum debt-to-equity ratio. Those
requirements are called debt covenants. A large purchase using debt financing could cause the
company to be noncompliant with those debt covenants and consequently trigger a default.

Enron's Off-Balance-Sheet Financing

Enron used 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. The company guaranteed the SPVs to reduce the level of risk involved. When
Enron's stock began falling, the values of the SPVs went down, causing the company to enforce its
guarantees. 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.

Why company finance to use off balance sheet financing

 Company wants to acquire new premises

 Merchant bank sets up a special purpose company to acquire client’s properties. Loans
secured on properties
 Company leases properties
 Rents pay loan interest
 End of initial lease, clients can :
i, buy leased properties; or

ii, sell properties and repay

 Enron-Uses special purpose vehicles to keep debts off balance sheet
-Treats loans as sales
-Swaps assets and treats them as sales
 WorldCom – Capitalizes revenue expenditures

 Xerox – Premature recognition of leasing

 Adelphi Communications – the owners looted company and used it as “personal piggy bank”

 Satyam – Used the loopholes in the accounting standards, played with the financial
statements for more than a decade
Risk

A business usually doesn't have to include an item on the balance sheet because the item is
neither an asset nor a liability. With a liability, the business eventually has to pay out money
to an external party; for example, the bank that lends loan funds. Because the off-balance
sheet item is not a liability, it poses little risk to the company. A business may turn an item
into a non-liability by taking out a renewable lease instead of a loan it has to pay off, or by
transferring the risk to a separate legal entity.

Borrowing Capacity

When a business takes on a new loan, it increases its debt burden. With off-balance sheet
financing, the business obtains the funds or items it needs without affecting its debt burden.
Because a business usually has a maximum amount of funds it can borrow, off-balance
sheet financing gives the business the ability to use its remaining allowable borrowing
capacity for other purposes. In this way, off-balance sheet financing allows the business to
accomplish more tasks.

Relationships

When a business signs a contract with a supplier or lender, the contract may require that
the business limit its debt to a certain level. If the business needs funds or equipment and
decides to take on a new loan, it may exceed the contractual limit. In the case of large
corporations, the business may also have to obtain the approval of the directors to get new
debts. Because off-balance sheet financing does not involve the business taking on debt, it
does not affect a business' relationship with suppliers, lenders or directors.

Reported Numbers

Off-balance sheet financing does not affect the business' reported numbers and ratios. For
example, the business will have the same levels of return on assets and debt ratio. In
contrast, a loan often affects a business' reported numbers and ratios negatively, making it
look less attractive to analysts, investors and creditors. Off-balance sheet financing makes
the business appear financially healthier than if it were to obtain debt.