What is off-balance sheet financing (OBSF)?
Off-balance sheet financing (OBSF) is an accounting practice by which companies record certain assets or passive in a way that prevents them from appearing on the balance sheet. It is used to keep debt (D / E) and leverage ratios low, especially if the inclusion of a large expense would break the debt covenants.
Examples of off-balance sheet financing (OBSF) include joint ventures (JV), research and development partnerships (R&D) and operating leases.
Understanding off-balance sheet financing (OBSF)
Companies sometimes take a creative approach when making large purchases. Those who have mountains of debt will often do whatever it takes to ensure that their leverage ratios do not lead to the violation of their agreements with lenders, otherwise known as covenants.
They will also keep in mind that a healthier balance sheet is likely to attract more investors and that banks tend to charge more heavily indebted companies for borrowing money because they are more likely to default. .
Examples of off-balance sheet financing (OBSF)
Operating leases have proven to be one of the most popular ways to overcome these problems. Rather than purchasing equipment, a company rents or rents it, and then purchases it at a minimum price at the end of the rental period. Choosing this option allowed a company to record only the cost of renting the equipment. Reserve it as operating expense on the income statement leads to a decrease in the liabilities of its balance sheet.
Partnerships are another popular way to dress up balance sheets. When a business creates a partnership, it does not have to display the liabilities of the partnership in its balance sheet, even if it has a majority interest in it.
Key points to remember
- Off-balance sheet financing (OBSF) is an accounting practice by which companies record certain assets or liabilities in a way that prevents them from appearing on the balance sheet.
- It is used to keep debt / equity (D / E) and leverage ratios low, which facilitates cheaper borrowing and prevents breaches of covenants.
- Regulators have sought to limit questionable off-balance sheet funding (OBSF).
- Stricter reporting rules have been introduced to give more transparency to controversial operating leases.
Real example of Off-balance sheet financing (OBSF)
The dishonored energy giant Enron used a form of off-balance sheet financing (OBSF) known as special purpose vehicles (SPV) to hide its mountains of debts and toxic assets from investors and creditors. The company traded its rapidly rising shares for cash or SPV notes. The SPV used the stock to cover the assets of Enron’s balance sheet.
When Enron’s stock started to fall, the SPV values went down and Enron was financially responsible for their support. Because Enron was unable to repay its creditors and investors, the company filed for bankruptcy. Although SPVs were disclosed in the notes to the company’s financial documents, few investors understood the gravity of the situation.
OBSF is controversial and has drawn closer regulatory scrutiny since it was exposed as a key strategy of the miserable energy giant Enron.
Obligation to declare off-balance sheet financing (OBSF)
Companies must comply with the requirements of the Securities and Exchange Commission (SEC) and generally accepted accounting principles (GAAP) when disclosing off-balance sheet financing (OBSF) in the notes to its financial statements. Investors can study these notes and use them to decipher the depth of potential financial problems, although, as the Enron case shows, it’s not always as simple as it sounds.
Over the years, regulators, eager to prevent a repetition of Enron’s naughty tactics, have sought to further restrict questionable off-balance sheet financing (OBSF).
In February 2020, the Financial Accounting Standards Board (FASB), the issuer of generally accepted accounting principles, changed the rental accounting rules. He took action after establishing that public companies in the United States with operating leases were deferring more than $ 1 trillion in off-balance sheet financing (OBSF) for lease obligations. According to his findings, approximately 85% of leases have not been declared on the balance sheet, making it difficult for investors to determine the leasing activities of companies and their ability to repay their debts.
This off-balance sheet financing practice (OBSF) was targeted in 2019 when the update of accounting standards 2020-02 ASC 842 came into force. The assets and liabilities related to the rights of use resulting from rental contracts must now be entered in the balance sheet. According to the FASB: “A tenant is required to recognize the assets and liabilities of leases with a lease term of more than 12 months.”
Improved information in qualitative and quantitative reports in footnotes to financial statements is now also required. In addition, off-balance sheet financing (OBSF) for sale and leaseback transactions will not be available.
Regulators are seeking to make off-balance sheet financing (OBSF) more transparent. This will help investors, although it is likely that companies will still find ways to dress up their balance sheets in the future.
The key to identifying red flags in off-balance sheet financing (OBSF) is to read the entire financial statements. Look for keywords such as partnerships, rental or rental fees and take a critical look at them.
Investors can also contact company management to clarify whether off-balance sheet financing agreements (OBSF) are used and, hopefully, to determine to what extent they actually affect liabilities.