Off balance sheet financing is financing from sources other than debt or equity offerings, such as joint ventures, research and development partnership and operating leases. For complex institutions such as banks, they increase their use of off shore subsidiaries and swap transactions to avoid disclosing liabilities. In other words, off balance sheet accounting is a process which a business creates what is practically a debt that it must pay off, but the debt is accounted as another type of transaction that does not count as a liability. Similarly, this applies to asset too.
Operating leasing is the most common form of off balance sheet financing. With leasing, on the one hand, an entity could acquire the right to use an asset through a rental agreement. On the other hand, the entity could purchase the same asset using external finance. While the two arrangements may result in identical net cash flows to the entity, in the case of a purchase both the asset and the associated financing obligation appear on the entity’s balance sheet whereas in the formal scenario rental payments are accounted for as a period expense, with the asset corresponding liability omitted from the entity’s balance sheet.
Entities used Special Purpose Entities (SPE), are also known as Variable Interest Entities (VIE) for off balance sheet treatment of deals. SPE or VIE is a corporation or partnership formed for the purpose of borrowing money to buy financial assets. Debts are move to a newly created company (SPE OR VIE) specifically to make a company look like it has far less debt than it actually does, which was the case with Enron. For example, a company needs to finance a business venture but doesn’t want to take on the risk, or when there is too much debt to get a loan. By starting a new SPE, they can secure a loan through the new entity. There are situations where it makes sense to start a SPE. If a company wants to branch out into another area outside of its core business, a SPE...
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