how off balance sheet financing works
an operating lease used in off balance sheet financing obsf is a good example of a common off balance sheet item assume that a company has an established line of credit with a bank whose financial covenant condition stipulates that the company must maintain its debt to assets ratio below a specified level taking on additional debt to finance the purchase of new computer hardware would violate the line of credit covenant by raising the debt to assets ratio above the maximum specified level obsf is controversial and has attracted closer regulatory scrutiny since it was exposed as a key strategy of the ill fated energy giant enron 1the company solves its financing problem by using a subsidiary or special purpose entity spe which purchases the hardware and then leases it to the company through an operating lease while legal ownership is retained by the separate entity the company must only record the lease expense on its financial statements even though it effectively controls the purchased equipment the company does not have to recognize additional debt nor list the equipment as an asset on its balance sheet off balance sheet financing reporting requirementscompanies must follow securities and exchange commission sec and generally accepted accounting principles gaap requirements by disclosing obsf in the notes of their financial statements investors can study these notes and use them to decipher the depth of potential financial issues although as the enron case showed this is not always as straightforward as it seems in feb 2016 the financial accounting standards board fasb the issuer of generally accepted accounting principles changed the rules for lease accounting it took action after establishing that public companies in the united states with operating leases carried over 1 trillion in obsf for leasing obligations according to its findings about 85 of leases were not reported on balance sheets making it difficult for investors to determine companies leasing activities and ability to repay their debts 2this obsf practice was targeted in 2019 when accounting standards update 2016 02 asu 842 came into effect right of use assets and liabilities resulting from leases are now to be recorded on balance sheets according to the fasb a lessee is required to recognize assets and liabilities for leases with lease terms of more than 12 months 3enhanced disclosures in qualitative and quantitative reporting in footnotes of financial statements is also now required additionally obsf for sale and leaseback transactions will not be available example of off balance sheet activitythe enron scandal was one of the first developments to bring the use of off balance sheet entities to the public s attention in enron s case the company would build an asset such as a power plant and immediately claim the projected profit on its books even though it hadn t made one dime from it if the revenue from the power plant was less than the projected amount instead of taking the loss the company would then transfer these assets to an off the books corporation where the loss would go unreported enron once considered one of the most innovative and successful energy companies in the united states collapsed in 2001 amidst revelations of widespread accounting fraud and corruption the company had engaged in complex financial transactions and partnerships many of which were not properly disclosed in its financial statements these off balance sheet entities were used to hide debt and losses giving the appearance of financial health and profitability when in reality enron was facing significant financial troubles 4one of the most notorious off balance sheet entities created by enron was the special purpose entity discussed earlier in this article enron used spes to keep debt off its balance sheet thus presenting a much healthier financial picture to investors and analysts the company transferred assets and liabilities to these entities often through complicated financial maneuvers allowing enron to artificially inflate its reported earnings and hide its true financial condition 5