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.
An operating lease, used in off-balance sheet financing (OBSF), is a good example of a common off-balance sheet item.
Assume that a company has an established line of credit with a bank whose financial covenant condition stipulates that the company must maintain its debt-to-assets ratio below a specified level.
However, companies also use off-balance-sheet financing to preserve borrowing capacity (for example, when a company is close to hitting its limit on a borrowing line or would like to use its borrowing line for something else), lower their borrowing rates, or manage risk.
The strategy, however, has had a bad reputation since it was famously used by former energy giant Enron.The Enron scandal was one of the first developments to bring the use of off-balance-sheet entities to the public's attention.In Enron's case, the company would build an asset such as a power plant and immediately claim the projected profit on its books even though it hadn't made one dime from it.Once customers have paid up, the factor pays the company the balance due minus a fee for services rendered.In this way, a business can collect what is owed while outsourcing the risk of default. Therefore, Company XYZ needs to find another way to obtain a the machine.To solve the problem, Company XYZ creates a separate entity that will purchase the equipment and then lease it to Company XYZ via an , joint ventures, or research and development activities.For most companies, off-balance sheet items exist in relation to financing, enabling the company to maintain compliance with existing financial covenants.Off-balance sheet items are also used to share the risks and benefits of assets and liabilities with other companies, as in the case of joint venture (JV) projects.The company must only record the lease expense on its financial statements.Even though it effectively controls the purchased equipment, the company does not have to recognize additional debt nor list the equipment as an asset on its balance sheet.