Definition of off balance sheet financing
Financing that does not appear on a company's balance sheet because it is not strictly debt (so liabilities and associated assets are excluded from the balance sheet).
In certain circumstances this can have a flattering effect on important accounting ratios such as leverage and return on assets. Accordingly, published financial statements may fail to provide a full and transparent representation of the underlying activity of the reporting entity; in particular, reported results may suggest less exposure to liabilities than really exists.
Common off balance sheet financing mechanisms include consignment stock, sale and repurchase (or leaseback) arrangements, debt factoring, securitisation, creation of special purpose entities, and leasing.
With leasing, on the one hand, an entity could acquire the right to use an asset through a rental agreement. On the other hand, the entity could purchase the same asset using external finance. While the two arrangements may result in identical net cash flows to the entity,
in the case of a purchase both the asset and the associated financing obligation appear on the entity’s balance sheet whereas in the former scenario rental payments are accounted for as a period expense, with the asset and corresponding liability omitted from the entity’s balance sheet. Omission of the financing liability can have a flattering effect on key ratios such as leverage and interest coverage, while omission of the asset could help to inflate return on assets.
Sound commercial reasons may exist to explain the use off balance sheet financing. These include sharing with other parties the risks and benefits associated with certain assets and liabilities or gaining protection from selected risks. However, off balance sheet financing arrangements may also be motivated by wanting to reduce perceptions of risk or to camouflage the substance of particular transactions.
Textbook examples of off balance sheet financing activity include Enron (in the form of special purpose entities) and Southern Cross (in the form of operating leases.