Off-balance-sheet financing is an attempt to borrow monies in such a way to prevent recording the obligations.

Off-Balance-Sheet FinancingOff-Balance-Sheet Financing

Different Forms:

• Non-Consolidated Subsidiary

• Special Purpose Entity (SPE)

• Operating Leases

• Joint Ventures

• Project Financing Arrangement

Non-consolidated subsidiary. Under GAAP, parent

company does not to consolidate a subsidiary company that is less than 50% owned. Therefore, the company does not report the assets and liabilities of the subsidiary. All the parent reports on its balance sheet is the investment in the subsidiary. As a result, users of the financial statement may not understand that the subsidiary has considerable debt for which the parent may ultimately be liable if the subsidiary runs into financial difficulty

Leases. Another way that companies keep debt off the

balance sheet is by leasing. Instead of owning the assets, companies lease them. By meeting certain condition (the four lease classification criteria), the company has to report only rent expense and to provide note disclosure of the transaction.

Note that Special Purpose Entity (SPE) often use leases to

accomplish off-balance-sheet treatment.

Special Purpose Entity (SPE). A company creates

a SPE to perform a special project.I

Illustrate how SPE can serve as a form off-balance-sheet financing.

ABC Company requires use of a building costing $100,000. Rather than buy the building (with borrowed money), ABC facilitates the establishment of SPE Company. SPE Co. is started with $3,000 investment from a private investor (who is not associated with ABC Co.), with $97,000 bank loan. SPE now has $100,000 in cash which it purchases the $100,000 needed by ABC Co. SPE then leases the building to ABC, with the lease term to allow for the lease to be accounted for as an operating lease. After this series of transactions, the building-related and lease-related items on the balance sheets of ABC and SPE are as follow.

ABC Co. SPE Co.

Assets: Assets:

……………………………………….. $0 Building ………………………$100,000

Liabilities: Liabilities:

……………………………………….. 0 Bank loan …………………….. 97,000

Equity:

Paid in Capital …………… 3,000

• With the help of SPE, ABC now has use of the building but without any debt on its balance sheet. Thus, the creation of an “independent” SPE is another way to engage in off-balance-sheet financing.

• If SPE were classified as being “controlled” by ABC, the SPE’s book would be consolidated with those of ABC, and both the building and the bank loan would appear on ABC consolidated balance sheet

From the simple example, issues are crucial in the accounting for an SPE:

• How much outside equity financing of the SPE is necessary for the SPE to be considered an independent entity? The financing in this case 3% ($3,000/ $100,000)

• If the ABC is contingently liable for the SPE’s debt, is the SPE an independent entity?

• If the SPE only engages in transactions with ABC, is the SPE an independent entity?

The accounting rules allow for an SPE to be very dependent on its sponsoring company (small external investment, debt guaranteed by the sponsor, transactions only with the sponsor) yet still be accounted for as a separate company.

Special Purpose Entity (SPE) & What About GAAP?

As one analyst noted, Enron showed the world the power of the idea that” if investors can’t see it, they can’t ask you about it – the “it” being assets and liabilities.

What exactly did Enron do? First, it created a number of entities whose purpose to hide debt, avoid taxes, and enrich certain management personnel to the detriment of the company and its stockholders. In effect, these entities (SPE) appeared to be separate entities for which Enron had a limited economic interest; the risks and reward ownership were not shifted to the entities but remained with Enron. In short, Enron was obligated to repay investors in these SPEs when they were unsuccessful. Once Enron’s problem discovered, it soon became apparent that many other company had similar problem.

What About GAAP?

A reasonable to ask with regard to SPEs is, “why didn’t GAAP prevent companies from hiding SPE debt and other risks, by forcing companies to include these obligation in their consolidated financial statements?

FASB realized that changes had to be made to GAAP for consolidations, and it issued SFAS interpretation No.46 (revised), “Consolidation of Variable Interest Entities”. In this interpretation, FASB created a new risk-and-reward model to be used in situations where voting interests (more than 50%?) were unclear. This model answers the basic question of who stands to gain or lose the most from ownership in an SPE when ownership in uncertain.