This paper examines off-balance sheet items and their treatment in financial systems analysis. Balance sheets consist of information about a company's assets, liabilities, and owner's equity. Off-balance sheet information is described as any activity a company can engage in but not report on its balance sheet. Frequently these activities relate to liabilities incurred by companies. In some cases companies that attempt to keep information off-balance sheet may do so illegally, intending to present a stronger financial position (Thomason, 2011).
Off-Balance Sheet Accounting
Off-balance sheet accounting is a form of accounting for assets, debts or other financing activities that are not included on a company's main balance sheet. A company's financial wealth is typically determined by the total assets minus total liabilities listed on the balance sheet; if this number is positive, then the company has created financial wealth (Vitez, 2010).
Generally accepted accounting principles (GAAP) give companies the option of maintaining separate legal entities for accounting and tax purposes. Companies use off balance sheet accounting rules to transfer risk from the parent company to its subsidiaries, thereby protecting its investors, lenders, or other business interests. Subsidiary companies are also used to create new financing for business operations, while at the same time keeping the liability off the parent company's financial statement (Vitez, 2010).
Off-Balance Sheet Financing
Though minimal levels of off-balance sheet activity were acceptable in the past, the growing number of transactions became more of a concern during the 2008 financial crisis. Banks and other financial institutions carried excessive amounts of off-balance sheet financing that hid the risks that these institutions incurred (Thomason, 2011).
Off-balance sheet financing is accomplished by any form of funding that avoids placing owners' equity, liabilities or assets on a firm's balance sheet. Generally speaking, off-balance sheet financing is accomplished by placing those items on some other entity's balance sheet. A standard approach to doing this is for a company to form a special purpose vehicle (SPV) and place assets and liabilities on its balance sheet. An SPV is also called a special purpose entity (SPE), and is a firm or legal entity established to perform some narrowly defined or temporary purpose. The sponsoring firm accomplishes that purpose without having to carry the associated assets or liabilities on its own balance sheet; it achieves its purpose off the balance sheet (Holton, 2005).
The sponsoring firm typically takes only a partial ownership position or no ownership interest in the SPV whatsoever. SPVs are used in a variety of transactions, including leasing, project finance, and securitizations. SPVs can take various legal forms, including corporations, U.S.-style trusts or partnerships (Holton, 2005).
Off-balance sheet financing offers advantages from a risk management standpoint. When assets and liabilities are moved from one balance sheet to another, the risks associated with those assets and liabilities go with them to the other balance sheet. Therefore, if a firm transfers credit-risky assets to an SPV, the credit risk goes with those assets (Holton, 2005).
Off-balance sheet financing offers considerable flexibility. An SPV does not use the sponsoring firm's credit lines or other financing channels; instead it is presented to financiers as a stand-alone entity with its own risk-reward characteristics. It can issue its own debt or establish its own lines of credit (Holton, 2005).
Off-balance sheet financing is often used as a means of asset-liability management; if assets and liabilities are never placed on the balance sheet, then they do not have to be matched. SPVs can also be used in tax avoidance. Banks use off-balance sheet financing to achieve reductions in their regulatory capital requirements. While SPVs and off-balance sheet financing can have legitimate purposes, they can also be used to misrepresent a firm's financial condition. Prior to its bankruptcy, Enron created numerous SPVs which they used to hide billions of dollars in debt. As a result of that abuse and other scandals during 2001-2002, laws, regulations and accounting rules were tightened (Holton, 2005).
Off-Balance Sheet Leases
Off-balance sheet leases can be used as a means to shift debt off a company's balance sheet. Not to be confused with a capital lease, which is treated like a purchase and shows up on the company's balance sheet, an operating lease transaction allows the lessor to retain ownership of the leased asset. Operating lease payments appear as operating expenses for the company using a lease to purchase the asset. This arrangement allows a company to keep substantial liabilities from plain sight (McClure,…