Effects of Off-Balance Sheet Financing

Question 1

What is the purpose of off-balance sheet-financing?

Answer 1

Reducing a company’s debt load improves its ratios, making its securities more attractive investments. Also, many loan covenants contain restrictions on the total debt load that a company is permitted to carry

Reducing debt and hiding it are two very different things. Firms that carry extensive debt financing but attempt to disguise the fact are engaging in off-balance-sheet financing

Eliminating debt from the balance sheet through off-balance-sheet financing will improve a company’s debt to equity ratio because there will be less debt reported

Question 2

What are the principal forms of off-balance-sheet financing?

Answer 2

Off-balance-sheet-sheet financing takes four principal forms:

1. Investments in unconsolidated subsidiaries
2. Special purpose entities
3. Operating leases
4. Factoring receivable with recourse

Question 3

How are investments in unconsolidated subsidiaries a form of off-balance-sheet financing?

Answer 3

Any equity ownership of less than 50% in a subsidiary results in the parent firm reporting the equity investment as an asset

The result is that the subsidiary’s debts (for which the parent could be substantially responsible) are NOT reflected as liabilities of the parent

Establishing a joint venture will accomplish the same purpose as an unconsolidated subsidiary because joint ventures are usually accounted for on the equity basis since none of the ventures are typically considered to hold control

Question 4

How are special purpose entities a form of off-balance-sheet financing?

Answer 4

A firm may create another firm for the sole purpose of keeping liabilities associated with a specific project off the parent firm’s books

For example, when a company wishes to construct a factory, large amounts of new debt must be taken on. A special purpose entity (SPE) can be established solely to build and operate the new plant while absorbing the debt incurred during construction

Once the plant is complete, the parent firm will often establish take-or-pay contract with SPE. Under a take-or-pay arrangement, the company agrees to either buy all the output of the factory or to make guaranteed payments

This way, the financial solvency of the SPE is ensured and the company has acquired a steady source of supply without taking on a large debt burden

Note: Enron essentially created SPEs for the purpose of hiding debt and keeping it off their financials. FASB issued pronouncements on VIE’s because of this. Any arrangement that meets the criteria of a VIE must be reported on a consolidated basis with another entity

Question 5

How are operating leases a form of off-balance-sheet financing?

Answer 5

A long-term contract to acquire property or equipment may be structured in such a way that the full amount of the debt does NOT appear on the firm’s balance sheet

Question 6

How are factoring receivables with recourse a form of off-balance-sheet financing?

Answer 6

Factoring (selling) accounts receivable to finance a company is a strategy used by firms who need to accelerate their cash flows or who simply do NOT wish to maintain a collection operation

If the factoring transaction is “WITH RECOURSE,” the firm remains contingently liable to the finance company in case of debtor default. This contingent liability does NOT have to be reported on the company’s balance sheet