Which of the following is an example of off-balance sheet financing

Off balance sheet financing occurs when a company partakes in some sort of financial obligation that does not show up on its balance sheet. The purpose of keeping such transactions off the balance sheet is to make a company seem financially strong and enticing to potentially investors. There are many ways that off balance sheet financing can be achieved, including through credit default swaps, subsidiary companies, and operating leases. This practice can be controversial and has been at the heart of several financial collapses, most notably in the Enron financial scandal in the United States.

Companies can go to great lengths to make themselves seem profitable to investors, and they often do this by boasting of positive balance sheets. A balance sheet is a financial document that lists all of a company's assets and liabilities, and it is used to show how much these assets are worth compared to the debt being incurred. Any company that successfully eliminates any liabilities or debt from its financial reporting while still actually taking on those negative numbers is practicing off balance sheet financing.

It is important to understand that not all off balance sheet financing is nefarious or illegal. For example, a company that uses operating leases is actually practicing a form of it. While the leased asset still technically shows up on the balance sheet of the entity that actually holds ownership of it, the company that is leasing it still has use of it. That company can also write off the money paid to lease the asset as an expense on its tax report.

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On the other hand, off balance sheet financing can also be problematic when practiced by large financial institutions that are crucial to the overall economic health of an economy. Banks often issue loans to customers and then sell off the loans to investors as securities. The bank can boast of the profits of these so-called credit default swaps, but it is also still subject to the risk of the customer defaulting. This risk doesn't appear on the bank's balance sheet but can become a real problem if multiple defaults occur.

Perhaps the notorious example of off balance sheet financing occurred in the United States with the Enron financial scandal that unfolded in 2001. Enron was a fast-rising energy company located in the state of Texas in the US, and its leaders were able to use subsidiary companies and partnerships to hide assets that were either overvalued or simply imaginary. Through questionable accounting, the company kept its own financial records looking spotless while it was actually tumbling towards bankruptcy. The resulting scandal led to closer inspection of the balance sheet accounting of large companies.

When small businesses need funds to expand, purchase assets or hire personnel, they may use debt financing if they are sufficiently creditworthy. These debt financing transactions appear on the cash flow statement and on the balance sheet. Occasionally, businesses will use debt financing to finance projects, subsidiaries and other assets in which they own a minority stake. When this occurs, the debt used may not show up on the cash flow statement and balance sheet.

Understanding Off-Balance-Sheet Basics

The definition of off-balance-sheet is nearly literal. According to Accounting Tools, "off-balance-sheet" means it does not appear on the balance sheet of a company's financial statements. Off-balance sheet financing is a legitimate, legal and permissible accounting method recognized by Generally Accepted Accounting Principles, or GAAP, as long as GAAP classification methods are followed. This form of financing is nearly always debt financing, so the debt does not appear as a liability on the balance sheet.

Off-Balance-Sheet Goals

Investopedia reports that the goal of off-balance sheet financing is to reduce or maintain a company's debt at or below a prescribed level so that its debt-to-equity ratio is low. When a company has a favorable ratio, that company appears to be a good credit risk, which is good news for businesses who need financing or investors to grow. In addition, a company may have other debt, including bank loans or bonds, that requires the company to maintain a minimum debt-to-equity ratio. Those requirements are called debt covenants. A large purchase using debt financing could cause the company to be noncompliant with those debt covenants and consequently trigger a default.

Off-Balance-Sheet Examples

When companies own a minority stake in another company, that stake may be eligible for treatment as an off-balance sheet item and any debt financing associated with that asset will typically be treated the same way. Hence, joint ventures, strategic or R&D partnerships and large projects are often financed off-balance-sheet. Enron collapsed under the weight of off-balance-sheet financing, appropriate and inappropriate, it had engaged in for myriad utility and pipeline projects, joint ventures and strategic partnerships.

Operating Lease Example

Operating leases are a more common example of off-balance-sheet financing. With an operating lease, the lessor keeps the asset on its balance sheet and the company leasing the asset only reports the rental expense. Its opposite, a capital lease, would show up as a liability on the lessee's balance sheet, and the leased asset as an asset on the lessee's balance sheet.

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