Off balance sheet financing generally implies financing from activities not on the corporate balance sheet, such as operating leases, joint ventures, and research and development partnerships. Differentiate these to loans, debt and equity, which do appear on balance sheets.
With this type of financing, larger capital expenditures are left off the balance sheet by classifying them through various methodologies to keep debt to equity and leverage ratios low. This is especially true if negative debt covenants would be broken by including the large expenditures on the balance sheet.
Off balance sheet financing items, most commonly operating leases, must follow the rules of the Generally Accepted Accounting Principles (GAAP) in the United States, in determining whether a lease should be expensed or capitalized. In the case of being expensed, the leased asset remains on the lessor’s balance sheet, and the lessee only expenses the actual rental charge of the asset.
Many U.S. corporations have structured subsidiaries and partnerships in an effort to prevent billions of dollars in debt from appearing on their balance sheets. If a corporation creates a special-purpose entity (SPE) with a 3% minimal equity infusion, no transaction consolidation is required under the Securities and Exchange Commission (SEC) or the Financial Accounting Standards Board (FASB) rules. Various banks arrange many of these structures and utilize them also.
Off balance sheet financing became popularly known during Enron Corporation’s bankruptcy travails in 2002, as many of the company’s financial problems were a result of questionable accounting practices in relation to off balance sheet entities. Since Enron’s failure, this type of financing is becoming more scrutinized by government entities.
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