Off-balance sheet financing allows companies to borrow money without recording the associated obligations on their balance sheet. This is accomplished through various structures like non-consolidated subsidiaries, special purpose entities (SPEs), operating leases, and joint ventures. SPEs in particular allow companies to keep assets and liabilities off their books by transferring them to an independent entity, even if the company remains responsible for the SPE's debts. In response to Enron and other accounting scandals, the FASB issued new rules focusing on risk and rewards to better determine when SPEs should be consolidated with their parent company.

1. Off-Balance-Sheet Financing
Off-Balance-Sheet Financing
Off-balance-sheet financing is an attempt to borrow
monies in such a way to prevent recording the obligations.
Different Forms:
• Non-Consolidated Subsidiary
• Special Purpose Entity (SPE)
• Operating Leases
• Joint Ventures
• Project Financing Arrangement

2. Non-consolidated subsidiary. Under GAAP, parent company
does not to consolidate a subsidiary company that is less than
50% owned. Therefore, the company does not report the assets
and liabilities of the subsidiary. All the parent reports on its
balance sheet is the investment in the subsidiary. As a result,
users of the financial statement may not understand that the
subsidiary has considerable debt for which the parent may
ultimately be liable if the subsidiary runs into financial difficulty
Leases. Another way that companies keep debt off the balance
sheet is by leasing. Instead of owning the assets, companies lease
them. By meeting certain condition (the four lease classification
criteria), the company has to report only rent expense and to
provide note disclosure of the transaction.
Note that Special Purpose Entity (SPE) often use leases to
accomplish off-balance-sheet treatment.

3. Special Purpose Entity (SPE). A company creates a SPE
to perform a special project.
I
Illustrate how SPE can serve as a form off-balance-sheet financing.
ABC Company requires use of a building costing $100,000. Rather
than buy the building (with borrowed money), ABC facilitates the
establishment of SPE Company. SPE Co. is started with $3,000
investment from a private investor (who is not associated with
ABC Co.), with $97,000 bank loan. SPE now has $100,000 in cash
which it purchases the $100,000 needed by ABC Co. SPE then
leases the building to ABC, with the lease term to allow for the
lease to be accounted for as an operating lease. After this series
of transactions, the building-related and lease-related items on
the balance sheets of ABC and SPE are as follow.

4. ABC Co. SPE Co.
Assets: Assets:
……………………………………….. $0 Building ………………………$100,000
Liabilities: Liabilities:
……………………………………….. 0 Bank loan …………………….. 97,000
Equity:
Paid in Capital …………… 3,000
• With the help of SPE, ABC now has use of the building but without
any debt on its balance sheet. Thus, the creation of an “independent”
SPE is another way to engage in off-balance-sheet financing.
• If SPE were classified as being “controlled” by ABC, the SPE’s book
would be consolidated with those of ABC, and both the building and
the bank loan would appear on ABC consolidated balance sheet

5. From the simple example, issues are crucial in the
accounting for an SPE:
• How much outside equity financing of the SPE is
necessary for the SPE to be considered an
independent entity? The financing in this case 3% ($3,000/
$100,000)
• If the ABC is contingently liable for the SPE’s debt,
is the SPE an independent entity?
• If the SPE only engages in transactions with ABC, is
the SPE an independent entity?
The accounting rules allow for an SPE to be very dependent on its
sponsoring company (small external investment, debt guaranteed by
the sponsor, transactions only with the sponsor) yet still be
accounted for as a separate company.

6. Special Purpose Entity (SPE) & What About GAAP?
As one analyst noted, Enron showed the world the power of
the idea that” if investors can’t see it, they can’t ask you
about it – the “it” being assets and liabilities.
What exactly did Enron do? First, it created a number of
entities whose purpose to hide debt, avoid taxes, and enrich
certain management personnel to the detriment of the
company and its stockholders. In effect, these entities
(SPE) appeared to be separate entities for which Enron had
a limited economic interest; the risks and reward ownership
were not shifted to the entities but remained with Enron.
In short, Enron was obligated to repay investors in these
SPEs when they were unsuccessful. Once Enron’s problem
discovered, it soon became apparent that many other
company had similar problem.

7. What About GAAP?
A reasonable to ask with regard to SPEs is, “why didn’t GAAP
prevent companies from hiding SPE debt and other risks, by
forcing companies to include these obligation in their
consolidated financial statements?
FASB realized that changes had to be made to GAAP for
consolidations, and it issued SFAS interpretation No.46
(revised), “Consolidation of Variable Interest Entities”. In
this interpretation, FASB created a new risk-and-reward
model to be used in situations where voting interests (more
than 50%?) were unclear. This model answers the basic
question of who stands to gain or lose the most from
ownership in an SPE when ownership in uncertain.