What Is Off-Balance Sheet Financing?Defined with Examples & More
Off-balance sheet financing (OBSF) is a practice in which a company excludes some liabilities or assets from appearing on its balance sheet.
This is done in an attempt to keep leverage ratios, such as the debt-to-equity ratio, low in order to obtain financing at a lower interest rate, particularly if including a large expenditure on the balance sheet would cause the company to break any negative debt covenants.
Companies are permitted to use off-balance sheet financing as long as they comply with accounting rules and regulations.
Off-Balance Sheet Financing (OBSF) Explained
Businesses with a lot of debt tend to be willing to do a lot to make sure their leverage ratios don’t reach the point that would break their covenants with their lenders.
However, these businesses also want a balance sheet that will look good to potential investors.
So, to do both of these things, businesses sometimes use off-balance sheet financing.
OBSF is an accounting method in which businesses record some of their liabilities and assets in a way that keeps them off of the business’s balance sheets.
However, even though these assets and liabilities don’t show up on the business’s balance sheet, they are still held by the business.
Off-balance sheet financing is a popular accounting strategy for companies that are highly leveraged.
These businesses often use OBSF if accumulating more debt would result in an increased debt-to-equity ratio.
When a company takes on more debt, it means it has an increased risk of default.
Therefore, lenders charge higher interest rates. In this strategy, companies leave specific capital expenditures or assets off of the balance sheet.
How Does OBSF Work?
OBSF is used for various purposes. As an example, suppose Company X wants to expand and would like to buy equipment for a new location.
Company X is already heavily financed and does not have a financing agreement already arranged.
This company would like to keep from adding a new liability to its balance sheet.
Therefore, the company could choose to enter a long-term lease to obtain the equipment.
With this option, the company would not need to obtain financing for the equipment.
Alternatively, the company could start a new venture with another company or investor and create a new entity.
Then, the company could arrange to finance in the name of the new entity. Each of these options is a form of off-balance sheet financing.
Off-Balance Sheet Financing Options
There are several ways companies can keep assets or liabilities off of their balance sheet, and we will discuss some of these.
Special Purpose Vehicles
Special purpose vehicles can be used by a company that wants to start a new line of business and yet limit its risks and liabilities.
Enron used this off-balance sheet financing method.
When a company creates a special purpose vehicle, it operates independently as its own entity and can obtain its own lines of credit.
However, if a company fully owns the SPV, the SPV’s balance sheet will typically need to be consolidated into its own.
This would eliminate the purpose the company had for the SPV of off-balance sheet financing.
So, in order to use off-balance sheet financing, companies generally enter a joint venture with another company or entity to create an SPV.
OBSF may sound questionable, but it is legal as long as accounting regulations or rules are followed.
For companies, leasing has long been used as a type of OBSF in the United States, and the generally accepted accounting principles (GAAP) must be followed.
However, if the proper rules and regulations are not followed, and the practice is used to cover up financial irregularities, it is illegal.
Investors should look at all of a company’s financial statements carefully and not just the balance sheet to ensure they obtain as much information as possible about a company before investing.
Leasing has long been used as a type of off-balance sheet financing.
If a business leases an asset, it can avoid having to include the financing of the new asset as a part of its liabilities.
Instead, the lease or rental payment is included as an expense in the company’s income statement.
Leasing is a common method of obtaining assets that would otherwise require a large capital outlay.
Additionally, leasing can help companies upgrade their technology without obtaining financing.
However, it is essential to remember that only operating leases can be used as a form of OBSF.
Financial leases are instead treated as an asset on the balance sheet of the business.
Factoring, also called accelerating cash flows, is another form of off-balance sheet financing.
This service is offered by some financial institutions and banks to their current customers.
In factoring, a financial institution or bank will purchase a portion of a business’s accounts receivable for cash.
Although, the bank will charge a factoring fee. Factoring does not result in liability as it is selling receivables.
Hire Purchase Agreements
Another form of OBSF companies can use is a hire for purchase agreement.
Companies can enter into these agreements with a financier for a specific period of time.
Under these agreements, the financier purchases the agreed-upon asset for the business, and the business agrees to make a fixed monthly payment as specified in the contract until the terms of the contract are fulfilled.
Once all payments are completed, the hirer owns the asset.
If the company uses normal accounting methods, the asset will be recorded on the balance sheet of the purchaser rather than the hirer’s balance sheet during the period of the agreement.
Reporting Requirements for OBSF
Businesses are required to comply with the requirements of the GAAP and the Securities and Exchange Commission (SEC) by disclosing their off-balance sheet financing in their financial statement notes.
These notes are useful for investors as they can use them to better understand the company’s financial issues, but these notes don’t always make the issues entirely clear.
Regulators have become stricter over time in an effort to reduce this type of questionable financial reporting.
In fact, in February 2016, the Financial Accounting Standards Board (FASB) made changes to the rules covering lease accounting.
The FASB made these changes once it established that public companies in the U.S. were carrying more than $1.25 trillion in leasing obligations for the purposes of off-balance sheet accounting.
The new standards require right-of-use assets and liabilities that are a result of leases to be recorded on the balance sheet.
Additionally, more extensive disclosures are now required to be included in the footnotes of a company’s financial statements.
Regulators are making it more difficult for companies to use off-balance sheet financing in an attempt to help investors get the information they need to make informed decisions when investing their money.
However, companies may still find ways to make their balance sheet look better than it should.
- Off-balance sheet financing is a strategy some companies use to keep certain liabilities and assets off of their balance sheet.
- Companies use off-balance sheet financing as a way to keep ratios, including debt-to-equity and other leverage ratios, low in order to obtain lower interest rates and avoid violating covenants.
- Regulators are strict about any suspicious off-balance sheet financing.
- Off-balance sheet financing is legal if the company complies with accounting regulations and rules.
- There are stricter reporting rules in place for making controversial operating leases more clear.
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NYU Stern "Off-Balance Sheet Financing Techniques" Page 1 - 12. August 30, 2022
NYU Stern "Off-Balance-Sheet Securitization, Bank Lending, and Firm Innovation" White paper. August 30, 2022