Off-balance Sheet Financing
Off-balance sheet financing refers to the activities that bring funds to the business but are not recorded in the company’s balance sheet. Companies usually do this so that they can keep their debts and expenditures low. In the book, The Secret Language of Financial Reports p. 141, Haskins says that, “Companies engage in off set financing so that they gain from using the assets without recording them. ” Examples of ways used to create off-sheet balancing include joint ventures, project finance, partnerships or being given a lease.
o Operating leases Leasing can be termed as renting out machinery, buildings or other assets for a given period of time. Companies never want to record any liabilities what they have speculated. Therefore, in order to keep their finances on point, they will structure leases sometimes on purpose so as to avoid having extra liabilities in their accounts. Operating leases are a major form of off-balance sheeting as the asset leased is recorded in the leaser’s balance sheet and the company giving the lease will only record the rent they get.
They can negotiate leases with no bargain purchase option, not giving away their privileges of ownership, and give discounts based on the present value. This will sound attractive to purchasers such that they will want the property without thinking much of the risks involved. By making it appealing, there main aim is to make sure that they gain in the long run. Leases’ not appearing in the company’s books does not mean that the company’s owners are not aware of what is going on. On contrary, the owners are informed of the future objectives of the company and making them aware of what is happening with the leases.
o Special purpose entities Special purpose entities (SPEs) refer to single purpose organizations created by a parent company and in which the parent company owns a small fraction of the company’s shares (Haskins, 2007). SPEs use their own assets and liabilities to run their organizations and fulfill their specific purposes. The SPEs will benefit because they can be given credit by the parent company to enable them run their business. SPEs are mainly used by the parent company like an intermediary such that they use them to sell assets to other organization so that they can get the money they need to pay off their debts.
Since the SPE is the one that carries out all the operations and operates as separate entity from the parent company, its assets and liabilities are excluded from the parent company balance sheet. This will be beneficial to the parent company because debts will not be shown in its accounts and they can use the SPEs to evade paying taxes. An example of SPEs is how some banks create special entities and use them to run mortgages and investments while operating as separate entities from the main bank. o Non-consolidated subsidiaries
A Consolidated subsidiary is one that is fully owned by a particular company in that the company has bought majority of the shares in the company. So in the financial statements the company will include assets and liabilities of the subsidiary in its accounts. When a company decides to consolidate another company (The subsidiary) by buying fewer shares; usually less than 50% then, the subsidiary is not controlled by the company. For this reason the company will consider the non- consolidated subsidiary as an investment and that is how it will be recorded in its books of account.
By doing this, ant debt that the subsidiary will incur will not be included in the companies balance sheet. When that subsidiary makes incurs a loss or makes profit, it will be recorded in the income statement but other details will be excluded. Motives for companies employing this practice Companies have many motives of employing this practice. This is because they have high chances of benefiting and hiding the several loopholes that come with bad debts therefore they will enhance their image and thus attract more investors.
Therefore they will be playing with the minds of investors and potential investors because they will be making themselves look good and reality they are not. “Through this, they will be increasing their shareholder value (Koller et al, 506). ” They will also benefit by transferring the risks that they would have otherwise faced to other companies which they have invested in or partnered with because they each business is operating differently therefore they will have different balance sheets and the major/parent company will not record some of the debts it has.
Companies can also use off-balance sheet financing as a way of generating capital to run the business because they will be using other enterprises to do business on their behalf and because of this will gain from the profits of other businesses as well as the liabilities of the company being less than the assets. “The motive for this practice is to gain from high capital costs and lower stock prices (Miller & Bahnson, 2002). ” Off-balance sheet financing also helps people to borrow because they will use other agents go get loans thus fund their accumulating debts.
The problem that comes with off-balance sheet financing is that leasers, partner businesses as well as investors and the general public are taken advantage of by the parent companies and this is seen as exploitation. This is because they are using dubious ways to deceive the public in the name of doing progressing themselves and this is not acceptable in business. They need to be accountable for their failures as they are of their successes and that is why record were created to keep track of the companies progress and not transfer those you do not want to other businesses.
The other businesses which they use and have no idea that they exploit, also want to make profits and grow and that is why there needs to be fair competition and respect in business. There are a number of companies who have used off set balancing. Some have benefited from it while others have paid a huge price for engaging in this practice. Airlines are the major uses of off-balance sheet financing when they offer operating leases for their planes.
This is because planes can be transferred from one airline to the next and there will always be a wiling candidate to accept the leases (Koller et al, 506). They therefore will get funds to pay off their debts. Ford Motor Company as well as General Motors have been able to raise money to pay off their debts and it has worked for them. A very unlucky company is Enron an energy company which collapsed because it had billions of dollars in debts which were well placed in special purpose entities accounts which it operated with and when the situation got out of control, it became bankrupt.