What Is Off-Balance Sheet Financing (OBSF)?

The term off-balance sheet (OBSF) financing refers to an accounting practice that involves recording corporate assets or liabilities in such a way that doesn't make them appear on a company's balance sheet. The practice is used to keep debt-to-equity (D/E) and leverage ratios low, especially if the inclusion of a large expenditure would break negative debt covenants. Off-balance sheet financing is a legal practice as long as companies follow accounting rules and regulations. It becomes illegal if corporate heads use it to hide assets or liabilities from investors and financial regulators

Understanding Off-Balance Sheet Financing (OBSF)

Companies with mountains of debt often do whatever they can to ensure that their leverage ratios do not lead their agreements with lenders, otherwise known as covenants, to be breached. By the same token, a healthier-looking balance sheet is likely to attract more investors. To meet these goals, they may need to turn to certain accounting strategies like OBSF.

Off-balance sheet financing is an accounting practice that allows companies to keep certain assets and liabilities off their balance sheets. Although they may not be present on the sheet, they still belong to the business. OBSF is commonly used by businesses that are highly leveraged, especially when taking on more debt means a higher debt-to-equity ratio. The more debt a company has, the higher the risk of default for the lender. This means charging the company a higher interest rate.1

This practice involves omitting certain capital expenditures or assets from the balance sheet. This means shifting ownership to other entities like partners or subsidiaries in which the company secures a minority claim. As such, examples may include joint ventures (JV), research and development (R&D) partnerships, and operating leases. Some corporations use special purpose vehicles (SPVs) with their own balance sheets to which they transfer these assets and liabilities. Although it sounds sketchy, off-balance sheet financing is a legitimate and very legal practice—as long as companies abide by established accounting rules and regulations. Companies in the United States are required to abide by generally accepted accounting principles (GAAP).3 The strategy becomes illegal when it is used to hide financial irregularities, as was the case with Enron.4

Example of Off-Balance Sheet Financing (OBSF)

Disgraced energy giant Enron used a form of off-balance sheet financing known as SPVs to hide mountains of debt and toxic assets from investors and creditors. The company traded its quickly rising stock for cash or notes from the SPV. The SPV used the stock for hedging assets on Enron's balance sheet.4

When Enron's stock began falling, the values of the SPVs went down, and Enron was financially liable for supporting them. Because Enron could not repay its creditors and investors, the company filed for bankruptcy. Although the SPVs were disclosed in the notes on the company's financial documents, few investors understood the seriousness of the situation.