What Are off-Balance Sheet Transactions?

Peter Hann

Off-balance sheet transactions represent financing that does not appear on the balance sheet of a company because the applicable accounting principles allow for a different treatment in the financial statements. Examples of such off-balance sheet transactions include the acquisition of assets on operating leases or the use of special-purpose vehicles such as partnerships or trusts. Using off-balance sheet transactions might be seen as beneficial to a company because the resulting liabilities are not shown on the balance sheet of the company, so its financial position might appear in a better light to investors or lenders.

A notorious example of off balance sheet financing occurred in the United States with the Enron financial scandal that unfolded in 2001.
A notorious example of off balance sheet financing occurred in the United States with the Enron financial scandal that unfolded in 2001.

By using off-balance sheet financing, a company might find it easier to obtain funding through equity capital or loans. When investors study the financial statements of a company, they give close attention to the liquidity of the company, one measure of which is the ratio of debt to equity. A company with high levels of debt compared to its equity capital might be seen as a relatively risky investment. Also, a high level of debt might make it more difficult for the company to obtain further loans. If some of the debt can be excluded from the balance sheet, the financial position of the company might appear in a better light, and this will improve the company's borrowing capacity.

An enterprise that needs to acquire an asset might decide either to lease or buy the asset. Where the lease is classified for accounting purposes as an operating lease, the asset does not need to be shown on the balance sheet. No liability is included on the balance sheet for the future payments due under the operating lease. If the lease is classified as a finance lease, the asset is shown on the balance sheet, and the corresponding liability for the capital element of the future lease payments is included. A company might aim to take out a lease that does not fall within the accounting definition of a finance lease and ensure that neither the asset nor the liability for the future payments under the lease need to appear on the balance sheet.

Off-balance sheet transactions can also be carried out through a special-purpose vehicle that is in reality controlled by the company, but the transactions engaged in by the entity do not need to be disclosed in the financial statements of the company. An entity such as a joint venture, partnership or trust could be used by a company to conduct off-balance sheet trading, taking on debt that might not need to appear on the company’s balance sheet. This type of entity has been used by some companies to disguise the true levels of debt incurred, leading to major accounting scandals and company failures. Generally accepted accounting principles have since been tightened up to restrict off-balance sheet transactions and prevent the recurrence of similar scandals. It is likely, however, that new schemes for disguising debt will continue to be devised and that further measures will be required to combat such schemes.

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