Off-Balance Sheet

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An-Najah NationalUniversity
College ofGraduate Studies
Masterof accounting program
balance sheet
-
Off
BY:
Ro’ya Abd El-hafez

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Table of content
Off-Balance Sheet definition: ............................................................. 3
Understanding Off-Balance Sheet...................................................... 3
What Is Off-Balance Sheet Financing? .............................................. 4
Types of Off-Balance Sheet Items ...................................................... 4
Operating Lease.............................................................................. 4
Leaseback Agreements.................................................................... 4
Accounts Receivables ...................................................................... 4
Special Purpose Vehicle (SPV)........................................................ 5
Hire Purchase Agreements.............................................................. 5
Factoring......................................................................................... 6
The fundamental off-balance sheet financing techniques .................. 6
How Off-Balance Sheet Financing Works.......................................... 6
Off balance sheet transactions as an element of risk management .... 7
Types of Off-Balance Sheet Activities ................................................ 7
Off-balance sheet transactions risk.................................................... 8
Advantages and Disadvantages of Off-Balance-Sheet Financing....... 9
The effect of off-balance sheet financing.......................................... 10
Example of a corporate scandal as an off-balance sheet result ........ 11
LIVEDOOR (JAPAN)................................................................... 11
References........................................................................................ 13

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Off-Balance Sheetdefinition:
Off-balance sheet (OBS) items is a term for assets or liabilities that
do not appear on a company's balance sheet. Although not recorded on the
balance sheet, they are still assets and liabilities of the company. Off-
balance sheet items are typically those not owned by or are a direct
obligation of the company. For example, when loans are securitized and
sold off as investments, the secured debtis often kept off the bank's books.
Prior to a change in accounting rules that brought obligations relating to
mostsignificant operating leases onto the balance sheet, an operating lease
was one of the most common off-balance items. (HAYES, 2021)
Understanding Off-Balance Sheet
Off-balance sheet items are an important concern for investors when
assessing a company's financial health. Off-balance sheet items are often
difficult to identify and track within a company's financial statements
because they often only appear in the accompanying notes. Also, of
concern is some off-balance sheet items have the potential to become
hidden liabilities. Forexample, collateralized debt obligations (CDO) can
become toxic assets, assets that can suddenly become almost completely
illiquid, before investors are aware of the company's financial exposure.
(HAYES, 2021)
Off-balance sheet items are not inherently intended to be deceptive
or misleading, although they can be misused by bad actors to be deceptive.
Certain businesses routinely keep substantial off-balance sheet items. For
example, investment management firms are required to keep clients'
investments and assets off-balance sheet. Formostcompanies, off-balance
sheet items exist in relation to financing, enabling the company to
maintain compliance with existing financial covenants. Off-balance sheet
items are also used to share the risks and benefits of assets and liabilities
with other companies, as in the case of joint venture (JV) projects.
(HAYES, 2021)
The Enron scandal was one of the first developments to bring the use
of off-balance-sheet entities to the public's attention. In Enron's case, the
company would build an asset such as a power plant and immediately
claim the projected profit on its books even though it hadn't made one
dime from it. If the revenue from the power plant was less than the
projected amount, instead of taking the loss, the company would then

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transfer these assets to an off-the-books corporation, where the loss would
go unreported. (HAYES, 2021)
What Is Off-Balance SheetFinancing?
Off-balance sheet financing is a form of financial, non-recourse debt
that companies use to raise more capital. It is one of
many accounting principles companies use. They typically raise more
capital than what they would put up if the project were shown on their
books. This means that it does not showup onthe company’s balance sheet
as a liability. Companies to reduce the amount of capital they have to put
up for a project can also use off-balance sheet financing. It helps keep their
leverage ratios looking healthy. Off-balance sheet financing is also known
as “off-balance sheet items” (FreshBooks, 2021)
Types of Off-Balance SheetItems
There are several ways to structure off-balance sheet items. The following
is a short list of some of the most common:
Operating Lease
An OBS operating lease is one in which the lessor retains the leased
asset on its balance sheet. The company leasing the assetonly accounts for
the monthly rental payments and other fees associated with the rental rather
than listing the asset and corresponding liability on its own balance sheet.
At the end of the lease term, the lessee generally has the opportunity to
purchase the asset at a drastically reduced price. (HAYES, 2021)
LeasebackAgreements
Under a leaseback agreement, a company can sell an asset, such as a
piece ofproperty, to another entity. They may then lease that same property
back from the new owner. (HAYES, 2021)
Like an operating lease, the company only lists the rental expenses on
its balance sheet, while the asset itself is listed on the balance sheet of the
owning business. (HAYES, 2021)
Accounts Receivables
Accounts receivable (AR) represents a considerable liability formany
companies. This asset category is reserved for funds that have not yet been
received from customers, so the possibility of default is high. Instead of
listing this risk-laden asset on its own balance sheet, companies can
essentially sell this asset to another company, called a factor, which then

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acquires the risk associated with the asset. The factor pays the company a
percentage of the total value of all AR upfront and takes care of collection.
Once customers have paid up, the factor pays the company the balance due
minus a fee for services rendered. In this way, a business can collect what
is owed while outsourcing the risk of default. (HAYES, 2021)
Special Purpose Vehicle (SPV)
Special purposevehicles or subsidiary companies are one of the
routine ways of creating off-the-balance sheet financing exposures. It was
used by Enron, which is known for one of the high-profile off-balance-
sheet financing exposure controversies .(Thakur, 2022)
1. The parent company creates SPV to enter a new set of activities but
wants to isolate itself from risks and liabilities from new activity.
(Thakur, 2022)
2. The parent company need not show the assets and liabilities of
SPV on its balance sheet. (Thakur, 2022)
3. The SPV acts as an independent entity and acquires its credit lines
for the new business. (Thakur, 2022)
4. Suppose the parent company fully owns SPV under accounting
standards for most countries. In that case, it needs to consolidate the
SPV balance sheet into its own, defeating the purpose of creating
off-balance sheet finance. Therefore, companies usually create SPV
through a new joint venture with another entity. (Thakur, 2022)
Hire Purchase Agreements
If a company cannot afford to purchase assets outright or obtain
finance for the same, it can enter into a hire purchase agreement for a
certain period with financiers. A financier will purchase the asset for the
company, which will pay a fixed amount monthly until all the terms in the
contract are fulfilled. The hirer can own the asset at the end of the hire
purchase agreement. (Thakur, 2022)
Under normal accounting, the assetreflects in the purchaser’s balance
sheet, and the hirer need not show it in its balance sheet during the period
of the hire purchase agreement. (Thakur, 2022)

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Factoring
Under factoring, finance is obtained by selling accountreceivables to
Banks. It is a type of credit service offered by Banks and other financial
institutions to their existing clients. Banks offer immediate cash to the
company after taking some cut from account receivables for offering the
service. (Thakur, 2022)
1. It is also termed as accelerating cashflows sometimes. (Thakur,
2022)
2. There is no direct liability on the companydue to factoring, but there
is a sale of some of its assets. (Thakur, 2022)
The fundamental off-balance sheet financing techniques used for
borrowing money and concealing debt are: (Saxunova, 2012)
1. Unconsolidated subsidiaries - equity swapping, parking transactions,
joint ventures Variable interest entities (VIEs), (old terminology: Special-
purpose-entities, special purpose vehicle companies).
2. Agreement and commitments creating obligations - Research and
development financing arrangements, Project financing arrangements,
Product financing arrangement, Third-party agreements, Through-put
agreements, Take-or-pay contracts.
3. The alteration of working capital, Securitization.
4. Hybrid instruments.
5. Leases – financial and operating, Synthetic lease, Sale and Lease-Back.
How Off-Balance SheetFinancing Works
An operating lease, used in off-balance sheet financing (OBSF), is a
good example of a common off-balance sheet item. Assume that a
company has an established line of credit with a bank whose financial
covenant condition stipulates that the company must maintain its debt-to-
assets ratio below a specified level. Taking on additional debt to finance
the purchase of new computer hardware would violate the line of credit
covenant by raising the debt-to-assets ratio above the maximum specified
level. (HAYES, 2021)

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OBSF is controversial and has attracted closer regulatory scrutiny
since it was exposed as a key strategy of the ill-fated energy giant Enron.
(HAYES, 2021)
The company solves its financing problem by using a subsidiary or
specialpurposeentity (SPE), which purchases the hardware and then leases
it to the company through an operating lease while legal ownership is
retained by the separate entity. The company must only record the lease
expense on its financial statements. Even though it effectively controls the
purchased equipment, the company does not have to recognize additional
debt nor list the equipment as an asset on its balance sheet. (HAYES,
2021)
Off balance sheettransactions as an elementof risk management
However, there is also roomfor a more honorable use of the term ‘off
balance sheet finance. Companies may, for sound commercial reasons,
wish to engage in transactions, which share with other parties the risks, and
benefits associated with certain assets and liabilities. Increasingly
sophisticated financial markets nowadays allow businesses to protect
themselves from selected risks, or to take limited ownership interests,
which carry the entitlement to restricted rewards of particular assets. Also,
off balance sheet transactions are often undertaken as an element of a
company's tax planning strategy. Such transactions are not undertaken to
mislead readers of their accounts, but because they are judged to be in the
best interests of the companies undertaking them. (Paterson, 2016)
Types of Off-Balance SheetActivities
Banks, in the event of seeking profit and increasing owners’ wealth,
have gone beyond traditional banking activities leading to the influx ofoff-
balance sheet activities (non-traditional banking activities). (Abor et al,
2019)
Banks tend to reduce the information made available to their deficit
units borrowers, while engaging in off-balance sheet lending activities. The
types of off-balance activities include guarantees (e.g. letters of credit),
loan commitments, loan sales and derivatives (The common types of
derivatives include futures contracts, forward contracts, options and swaps.
They are widely used to speculate on the future expectations or to reduce
risk (Abor et al, 2019). The most prominent points related to off-balance
sheet activities can be summarized as follows:

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1. In order to generate fee income through the reduction of transaction
costs, banks may engage in quite a number of activities such as providing
customised services. (Abor et al, 2019)
2. The reasons accounting for the growth of off-balance sheet activities are
increased volatility, giving rise to demand for risk management by
companies, interest rates changing continuously, etc. (Abor et al, 2019)
3. Off-balance sheet activities contribute to a significantly steady increase
in incomes generated by banks. (Abor et al, 2019)
4. There are risks associated with the extra income earned by banks through
their various off-balance sheet activities. (Abor et al, 2019)
5. The central bank can increase the level of required reserves of banks in
order to reduce their pool of excess reserves from which they engage in
off-balance sheet activities. (Abor et al, 2019)
6. Off-balance sheet fees can improve the earning ratios at a faster pace
than on-balance sheet fees. (Abor et al, 2019)
7. The volume and risk ofoff-balance sheet activities need to beconsidered
in the valuation of capital adequacy. (Abor et al, 2019)
8. Items of off-balance sheet activities are included in the notes to the
financial report only, and are not included in the main financial statements.
(Abor et al, 2019)
9. The rates of expansion in the performance of off-balance sheet activities
are linked with the prevailing economic policies in the country, especially
foreign transactions. (Al-Baz, 2019)
10. Banks provide services for off-balance sheet activities to their clients
based on the soundness of their financial positions; Banks may require
some additional guarantees from their customers in return for performing
these activities in the event of a high degree of associated risks. (Al-Baz,
2019)
Off-balance sheettransactions risk
Apart from credit risk, other risks that exist from off-balance sheet
transactions are settlement risk, liquidity risk, interest rate risk and
foreignexchange risk. Settlement risk is the risk of losing principal when
the bank pays the funds or foreign exchange even before it is certain that it
will receive the proceeds. Onthe other hand, liquidity risk refers to the risk
in which the bank is unable to convert their assets into cash in time and at
low costto meet their financial obligations, customer demand for loans, as
well as sudden withdrawal of funds. As a result, the bank have to rely on
higher costs of funding from the money market borrowing and offer a
higher interest to their depositors in order to obtain more funds in meeting
their financial obligations. This can be extremely costly for the bank

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becausethis will increase the interest expenses of the bank and squeeze the
bank’s profit. In addition, the bank may also face fluctuation in interest rate
when the bank engages itself in transactions in derivatives market. In this
case, the bank as a market-maker will increase its interest rate risk and
credit exposure. (Karim & Chan, 2007)
The off-balance sheet transaction may also cause an increase in the
bank's foreign exchange exposures. Thederivatives instrument may reduce
or rise with exposure to changes in exchange rate. (Karim & Chan, 2007)
Finally, OBS activities are not always risk increasing activities. In
many cases they are hedging activities designed to mitigate exposure to
interest rate risk, foreign exchange risk etc. OBS activities are frequently a
source of fee income, especially for the largest most credit-worthy banks.
(Saunders & Cornett, 2006)
Advantages and DisadvantagesofOff-Balance-SheetFinancing
Following are the advantages of Off-Balance-Sheet Financing: (e Finance
Management, 2022)
 It allows the company to keep its balance sheet lean, clean, and
attractive to investors.
 This way offinancing is legal, and thus, it allows businesses to better
manage their finances.
 Such a type of financing carries little risk in comparison to direct
financing methods.
 It allows companies to achieve their expansion and diversification
plans without burdening their balance sheet.
 A companydoes not need the permission of the stakeholders to carry
with its Off-Balance-Sheet Financing. This ensures that the
company’s relationship with investors, suppliers, and other
stakeholders does not get affected.
Following are the disadvantages of Off-Balance-Sheet Financing: (e
Finance Management, 2022)
 The company’s reputation may get spoiled if it is unable to pay its
off-balance sheet items. Also, this may make the company less
attractive to its investors. Such a type of financing could make the
company riskier because of its hidden liability.

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 Generally, a company goes for such financing if it is borrowing
beyond its limits. So, this may make investors doubt the financial
health of the company.
The effectof off-balance sheetfinancing
1- The off-balance sheet financing activities are linked to the asymmetry
of information. (Al-Segay et al, 2019)
2- The off-balance sheet financing has a significant impact on financial
leverage; The financial leverage ratio affects the value of the shares in the
market, which is reflected in the result on the total value of the assets in the
company. Since the value of changes in the value of shares is equal to
changes in the portfolio of assets; So it can be said that the financial
leverage ratio is the ratio of assets to stocks. Where, there is a relationship
between the financial leverage ofoff-balance sheet financing activities and
financial risks, and that the financial leverage does not depend on
indicators from within balance sheet only, but is also related to off-balance
sheet activities. (Al-Segay et al, 2019)
3- The off-balance sheet financing as a result of relying on external sources
of financing to a greater degree than on internal sources leads to an
imbalance in the financing structure. the financing structure is the structure
that helps to achieve financial balance between the elements ofthe external
financing structure; and the elements of the internal financing structure,
and then achieving a balance between the elements of the financing
structure and the elements of the asset structure so that the company’s
financial needs can be managed at the lowest cost and financial burden;
Reducing financial risks, maximizing annual profits and achieving a rate
of return on invested funds. (Al-Segay et al, 2019)
4 - As a result of the company’s off-balance sheet financing activities, the
assets or liabilities resulting from these activities are not recognized in the
financial statements; Thus, improving financial indicators such as the rate
of return on assets, the rate of return on equity and the debt ratio. This
means that the company's exclusion of some elements of assets and
liabilities from the statement of financial position helps to improve the
indicators of financial performance. ; This helps to maintain debt contracts
that require a maximum ratio of debt to equity. It makes it easier for them
to obtain new sources of financing in the future. (Al-Segay et al, 2019)

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5- off-balance sheet financing leads to a reduction in the cost of capital.
Whereas, off-budget financing is effective for obtaining loans at low cost.
Furthermore; The banks use of off-balance sheet financing helped them to
avoid many of the costs associated with the regulatory aspect, such as
minimum reserves, deposit insurance and capital adequacy requirements,
and thus could affect banking costs and profits. (Al-Segay et al, 2019)
6- The increase in the financing leasing activities leads to a decrease in
future profits; This result is consistent with diminishing marginal returns
on investment in financial leasing activities; Investors miscalculate the
future effects of financial leasing off-balance sheet ; lead to misleading
investors' expectations. (Al-Segay et al, 2019)
7- After the collapse of Enron, studies showed that the company's
undeclared obligations amounted to more than (1) billion dollars, which
many considered one of the main reasons for bankruptcy. In addition,
increase in profits resulting from off-balance sheet financing is
accompanied by an increase in its exposure to risks. Such activities have
the potential to cause serious harm to banks and companies when a
financial crisis occurs;Thefinancial crisis caused damage worth 11 trillion
dollars to the banking sector, and off-budget financing was one of the most
important reasons. Where the off-balance sheet can be used as an early
warning indicator of the occurrence of financial crises. (Al-Segay et al,
2019)
8- There is a close relationship between the financial risks of off-balance
sheet financing activities and the continuity of the economic entity. This
relationship stems from the fact that off-balance sheet financing activities
result in the existence of obligations on the economic entity that are not
recognized in the financial statements. These obligations, when taken into
account, lead to an increase in the debt-to-equity ratio, and thus increase
the financial risks that the economic entity may be exposed to; Which in
turn leads to bankruptcy. (Al-Segay et al, 2019)
Example of a corporate scandalas an off-balance sheetresult
LIVEDOOR (JAPAN)
The internet conglomerate company whose shares were traded on the
Tokyo Stock Exchange reported a fourfold increase in consolidated
operating income from 2003 to 2004. However, it was revealed that the
company had reported fictitious revenue of 5.2 billion yen and that the

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company would have reported a consolidated operating loss without
manipulation. The company used special purpose entities as off-balance
sheet vehicles to hide losses and illegally book capital transactions as
income in its accounts. As soon as the news of the accounting scandal
spread, a sell-off of Livedoor’s shares was sparked and the benchmark
Nikkei 225 declined by 5.4 %. The Tokyo Stock Exchange shut down its
entire trading operations after the news prompted a sell-off threatening to
crash its computer system. The event became known as the ‘Livedoor
Shock’. (Jones, 2010)

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References
Abor, J. Y., Gyeke-Dako, A., Fiador, V. O., Agbloyor, E. K., Amidu, M.,
& Mensah, L. (2019). Money and Banking in Africa. Advances in
African Economic, Social and Political Development. Ghana:
Springer, Cham.
Al-Baz, M. M. (2019). An Analytical Accounting Framework for the
Relationship between Off-Balance Sheet Activities and Financial
Risks and its Impact on the Competitive Banking Advantage: A
Proposed index and Evidence from the Egyptian Environment.
Journal of Accounting Research, pp. 446 - 490.
Al-Segay, M. M., Al-Ghandour, M. A., & Khalifa, N. M. (2019). A
proposed framework for the recognition and disclosure of off-
balance financing activities and its impact on the value of the
enterprise - an empirical study. Scientific Journal of Business and
Environmental Studies, pp. 59-108.
e Finance Management. (2022). Off-Balance-SheetFinancing – Meaning,
Methods, Example, and More. Retrieved from
efinancemanagement.com:
https://efinancemanagement.com/sources-of-finance/off-balance-
sheet-financing
FreshBooks. (2021). What Is Off-Balance Sheet Financing? Definition &
Example. Retrieved from www.freshbooks.com:
https://www.freshbooks.com/en-au/hub/accounting/off-balance-
sheet-financing
HAYES, A. (2021). Off-Balance Sheet (OBS). Retrieved from
www.investopedia.com:
https://www.investopedia.com/terms/o/off-balance-sheet-obs.asp
Jones, M. J. (2010). Creative Accounting, Fraud and International
Accounting Scandals. New York: John Wiley & Sons Ltd.
Karim, M., & Chan, S.-G. (2007). Off-Balance Sheet Activities and
Performance of Commercial Banks in Malaysia. ICFAI Journal of
Financial Economics, 5(4), pp. 67-80.
Paterson, R. (2016). Off balance sheet finance. London: Palgrave
Macmillan.

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Saunders, A., & Cornett, M. M. (2006). Financial Institutions
Management:A Risk ManagementApproach. New York: McGraw-
Hill.
Saxunova, D. (2012). Off-balance-sheet-financing and its Impact on
Reported Earnings of Slovak Banks. Conference: Emerging Trends
in Finance & AccountingAt: Mysore, (pp. 1-19). Mysore: SDM
Institute forManagement Development.
Thakur, M. (2022). Off-Balance Sheet Financing. Retrieved from
www.wallstreetmojo.com: https://www.wallstreetmojo.com/off-
balance-sheet-financing/#h-key-features

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