Off-Balance Sheet Financing

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Description of Off-Balance Sheet Financing. Explanation.



Off-Balance Sheet Financing

Definition Off-Balance Sheet Financing. Description

Off-Balance Sheet Financing refers to an accounting technique in which a liability or capital expenditure is not recognized on a company's balance sheet as a liability.

Off-Balance Sheet Financing can be used by a company  to pursue new business opportunities without disrupting the  current businesses. Also companies may use it in order to keep their Debt to Equity Ratio low and thereby appearing to be in a better financial position. Keeping debt off the balance sheet allows a company to appear more creditworthy, but may misrepresent the firm's financial structure to creditors, shareholders, and the public.

Forms of Off-Balance Sheet Financing. Types

The most common form of off-balance sheet financing is Operating Lease, in which a company rents, rather than buys, a Capital Asset. In operating lease the  cumulative liability for all future lease payments is not reflected on the lessee's balance sheet. Instead, only a portion of the obligation gets accrued as partial performance takes place under the lease.

Less frequently used types of off-balance sheet financing include Strategic Alliances, Joint Ventures, Special Purpose Vehicles and R&D Partnerships.

Off-Balance Sheet Accounting

Although both IAS/IFRS and U.S. GAAP require footnote disclosure of the lessee's future cash outflows arising from operating leases, there are many circumstances in which lessees are made better off by using the operating lease method.

One example are lending agreements which include Financial Covenants. Since most covenants are based on financial statement numbers, operating leases do not affect the conditions mentioned in them, such as maintaining a certain debt-to-equity ratio.

Furthermore, the operating lease accounting method keeps the leased asset off the balance sheet, and therefore produces a favorable impact on the lessee's Return on Net Assets Ratio that is just as substantial as the benefit that arises from omitting lease liabilities.

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