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 sheet 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 the undergoing expansion plan and wants to purchase machinery to establish the second unit in another state. However, it is not having a financing arrangement for same as its balance sheet is already heavily financed. In such a case, it has two options. It can set up a joint venture with other investors or company to establish a new unit and obtain fresh financing in name of the new entity. On other hands, it can also chalk out the long-term lease agreement with 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 ratio like Debt to equity ratio 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 accounting and financial instruments to achieve off the balance sheet finance.
List of Off-Balance Sheet Financing Items
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 asset 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 lessor bears the financing of the asset.
- The conventional method to acquire assets that require large capital outlay.
- It makes easier to upgrade technology with changing times.
- Only Operating leases 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 vehicles or subsidiary companies are one of the routine ways of creating off the balance sheet financing exposures. This was used by Enron which is known for one of the high profile off-balance sheet financing exposure controversies.
- The parent company 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 own credit lines 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 normally 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 certain period with financiers who 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 hirer need not show it in its balance sheet during the period of the hire purchase agreement.
#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 receivables for offering the service.
- It is also termed as accelerating cash flows 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 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 –