What is Off-Balance Sheet Financing?
Off-balance sheet financing is the company’s practice of excluding certain liabilities and in some cases assets from getting reported in the balance sheet in order to keep the ratios such as debt-equity ratios low to ease financing at a lower rate of interest and also to avoid the violation of covenants between the lender and the borrower.
It is a liability that is not directly recorded on the balance sheet of the company. Off-balance sheet items carry enough significance because even if they are not recorded on balance sheetRecorded On Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. finance, they are still the liability of the company and should be included in the overall analysis of the financial position of the company.
How Does It Work?
Suppose ABC Manufacturers Ltd is undergoing an expansion plan and wants to purchase machinery to establish the second unit in another state. However, it is not having a financing arrangement for the same as its balance sheet is already heavily financed. In such a case, it has two options. It can set up a joint ventureJoint VentureA joint venture is a commercial arrangement between two or more parties in which the parties pool their assets with the goal of performing a specific task, and each party has joint ownership of the entity and is accountable for the costs, losses, or profits that arise out of the venture. with other investors or companies to establish a new unit and obtain fresh financing in the name of the new entity. On the other hand, it can also chalk out the long-term lease agreement with the equipment manufacturer for the leasing of machinery, and in this case, it need not worry about obtaining fresh financing. Both of the above cases are examples of Off-balance sheet financing.
What is the Purpose of Off-Balance Sheet Items?
- To maintain solvency ratioSolvency RatioSolvency Ratios are the ratios which are calculated to judge the financial position of the organization from a long-term solvency point of view. These ratios measure the firm’s ability to satisfy its long-term obligations and are closely tracked by investors to understand and appreciate the ability of the business to meet its long-term liabilities and help them in decision making for long-term investment of their funds in the business. like Debt to equity ratioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. below a certain level and obtain funding which company would not have been able to obtain otherwise.
- Better solvency ratios ensure maintaining a good credit rating, which in term allows the company to access cheaper finance.
- It makes balance sheet finance appear leaner, which prima facie may attract investors.
- It results in the reduction in existing assets or exclusion of assets going to be created from the balance sheet.
- There is a change in the Capital structure of the company.
- Assets and liabilities are both understated, and it gives a leaner impression of the balance sheet finance.
- It involves the use of creative accountingCreative AccountingCreative accounting is a method used to make or interpret accounting policies falsely to misuse the accounting techniques and standards set by the accounting bodies. The purpose of doing so is to make profits by not reporting the exact figures and exploiting loopholes in our accounting system. and financial instruments to achieve off-balance sheet finance.
List of Off-Balance Sheet Financing Items
The following are some of the common instruments for off-balance-sheet Items.
#1 – Leasing
It is the oldest form of off-balance-sheet financing. Leasing an asset, allows the company to avoid showing financing of the assetFinancing Of The AssetAsset financing is defined as a loan taken out by an organization using balance sheet assets as collateral, such as land and buildings, vehicles, machinery, trade receivables, and short-term investments. The asset's value is divided into regular payment intervals of the asset's unpaid portion plus interest. from its liabilities and lease or rent is directly shown as an expense in the Profit & Loss statement.
- For the lessee, it is the source of financing as lessorLessorA lessor is an individual who legally owns the asset granted on a lease (rented for a long tenure) to the lessee who pays a single lump sum amount or regular payments for using that asset. bears the financing of the asset.
- The conventional method to acquire assets that require significant capital outlayCapital OutlayCapital outlay, or the capital expenditure, refers to the sum of money spent by the company to purchase the capital assets such as plant, machinery, property, equipment or for extending the life of its existing assets to increase production capacity.;
- It makes it easier to upgrade technology with changing times.
- Only Operating leasesOperating LeasesAn operating lease is a type of lease that allows one party (the lessee), to use an asset held by another party (the lessor) in exchange for rental payments that are less than the asset's economic rights for a particular period and without transferring any ownership rights at the end of the lease term. qualify as off-balance-sheet financing, and financial leases are required to be capitalized on the balance sheet as per the latest Indian Accounting Standards.
#2 – Special Purpose Vehicle (SPV)
Special purpose vehiclesSpecial Purpose VehiclesA Special Purpose Vehicle (SPV) is a separate legal entity created by a company for a single, well-defined, and specific lawful purpose. It also serves as the main parent company's bankruptcy-remote and has its own assets and liabilities. or subsidiary companies are one of the routine ways of creating off the balance sheet financing exposures. It was used by Enron, which is known for one of the high profile off-balance-sheet financing exposure controversies.
- The parent companyParent CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies. creates SPV to enter into a new set of activities but wants to isolate itself from risks and liabilities from new activity.
- Parent company need not show the assets and liabilities of SPV on its balance sheet.
- The SPV acts as an independent entity and acquires its credit linesCredit LinesA line of credit is an agreement between a customer and a bank, allowing the customer a ceiling limit of borrowing. The borrower can access any amount within the credit limit and pays interest; this provides flexibility to run a business. for the new business.
- If the parent company fully owns SPV, then under accounting standard for most countries, it needs to consolidate the SPV balance sheet into its own, which defeats the purpose of creating off-balance sheet finance. Therefore usually, companies create SPV by way of the new joint venture with some other entity.
#3 – Hire Purchase Agreements
If a company cannot afford to purchase assets outright or obtain finance for the same, it can enter into a hire purchase agreement for a certain period with financiers. A financier will purchase the asset for the company, which in turn will pay a fixed amount monthly until all the terms in the contract are fulfilled. The hirer has the option of owning the asset at the end of the hire purchase agreement.
- Under normal accounting, the asset reflects in the balance sheet of the purchaser, and the hirer need not show it in its balance sheet during the period of the hire purchase agreementHire Purchase AgreementHire Purchase is a type of agreement in which the buyer of an asset chooses to pay for the asset in installments. A certain amount is paid as a down payment, and the rest is paid in installments that includes both principal and interest..
#4 – Factoring
It is a type of credit service offered by Banks and other financial institutions to their existing clients. Under factoring, finance is obtained by selling account receivables to Banks. Banks offer immediate cash to the company after taking some cut from account receivablesAccount ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet. for offering the service.
- It is also termed as accelerating cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. sometimes.
- There is no direct liability on the company due to factoring, but there is a sale of some of its assets.
Significance For Investors
Under accounting standards for almost all major countries, it is mandatory to make full disclosure of all the off-balance sheet financing items for the company for that particular year. Investors should take note of these disclosures to fully understand risks associated with such transactions.
Off-Balance Sheet Financing Video
This article has been a guide to what is Off-Balance Sheet Financing and its definition. Here we discuss how off-balance sheet Items works and the list of items used to create them. You may learn more about Advanced Accounting here –