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Concept Version 8
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Being Aware of Off-Balance-Sheet Financing

Off-Balance-Sheet-Financing represents rights to use assets or obligations that are not reported on balance sheets to pay liabilities.

Learning Objective

  • Explain what constitutes an off-balance-sheet financing item


Key Points

    • Off-Balance-Sheet-Financing represents financial rights or obligations that a company is not required to report on their balance sheets.
    • Off-Balance-Sheet-Financing can have a substantial effects on a company's financial health: Enron is a great example of this.
    • An analyst should always read the footnotes contained in the financial statements as they often either disclose off-balance-sheet-financing directly or provide enough information to determine if the company could potentially enter into off-balance-sheet-financing arrangements.

Terms

  • off-balance-sheet financing

    capital expenditures financed and classified it in such a way that it does not appear on the company's balance sheet

  • operating lease

    A lease whose term is short compared to the useful life of the asset or piece of equipment being leased.

  • subsidiary

    A company that is completely or partly owned and partly or wholly controlled by another company that owns more than half of the subsidiary's equity.


Full Text

Off-Balance-Sheet-Financing is associated with debt that is not reported on a company's balance sheet. For example, financial institutions offer asset management or brokerage services, and the assets managed through those services are typically owned by the individual clients directly or by trusts. While these financial institutions may benefit from servicing these assets, they do not have any direct claim on them.

The formal accounting distinctions between on and off-balance sheet items can be complicated and are subject to some level of management judgment. However, the primary distinction between on and off-balance sheet items is whether or not the company owns, or is legally responsible for the debt. Furthermore, uncertain assets or liabilities are subject to being classified as "probable", "measurable" and "meaningful".

An example of off-balance-sheet financing is an unconsolidated subsidiary. A parent company may not be required to consolidate a subsidiary into its financial statements for reporting purposes; however the parent company may be obligated to pay the unconsolidated subsidiaries liabilities.

Another example of off-balance-sheet financing is an operating lease, which are typically entered into in order to use equipment on a short-term basis relative to the overall useful life of the asset. An operating lease does not transfer any of the rewards or risks of ownership, and as a result are not reported on the balance sheet of the lessee. A liability is not recognized on the lessee's balance sheet even though the lessee has the obligation to pay an agreed upon amount in the future.

It is important to consider these off-balance-sheet-financing arrangements because they have an immediate impact on a company's overall financial health. For example, if a company defaults on the rental payments required by an operating lease, the lessor could repossess the assets or take legal action, either of which could be detrimental to the success of the company.

Jeffrey Skilling

Jeffrey Skilling is the former CEO of Enron, which was notorious for it's use of off-balance-sheet-financing.

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