Off Balance SheetYou are probably familiar with the standard ‘Big 3’ financial statements: balance sheet, income statement and cash flow statement. Used in conjunction, these three documents can tell a lot about a company’s financial position. An accountant or financial analyst can easily calculate a bevy of financial ratios, monitoring leverage, liquidity, solvency, and efficiency. With just these few metrics, analysts can assess a company’s ability to pay its bills on time, vet expansion plans and can even critique management’s handling of corporate assets.

Perhaps the analyst determined the company’s weighted average cost of capital is too high. By calculating the debt to equity ratio, a common measure of leverage, you determine there is an opportunity to lower the cost of capital by taking on more debt. This is because the interest expense on the debt ability can be written off.

Using Financial Analysis to Manage Risk

More importantly, an analyst or accountant may be able to detect risky behavior by the company by reviewing the financial statements. Shrewd analysts can see if the company needs to tighten up credit and collection policies with customers or raise cash to prevent a liquidity crunch through the use of a factoring company.

Reviewing financial statements can also assess the ‘quality’ of reported corporate earnings. For example, lesser-quality reports might show positive net earnings (on the income statement) but cash flows from operations that are decreasing (the cash flow statement).

As you can see, a trained analyst can ascertain a large amount of information from these basic financial statements. But what if these three statements don’t tell the whole story?

Off Balance Sheet Activity

Sometimes, companies execute transactions not recorded on any financial statement. These ‘off-balance sheet (OBS)” items are assets or liabilities that exist, but are not required by IFRS to be included on financial statements (balance sheet). Off-Balance sheet financing can de-emphasize (hide) a particular activity. Consistent use of off-balance sheet financing lowers the quality of earnings in many analyst’s eyes and can negatively affect both credit and equity ratings.

How Would a Company Use OBS Financing?

Here’s an example of how a company might utilize off-balance sheet activity. Let’s say a company currently has a high level of debt outstanding. It wants to make a large capital expenditure (buying a building) but doing so would cause the company’s debt-to-equity ratio to increase above a pre-determined threshold.

Exceeding the threshold would breach a covenant in a lending agreement the company has with its creditor, a commercial bank. A few things could happen following a breach, none of which are good-the bank could call in the loans, causing a potential bankruptcy if the company was stretched thin enough. The bank could restructure the existing loans with a higher interest rate. At the very least, it would raise future borrowing costs.

Instead, the company uses an operating lease with an off balance sheet entity that it creates, known as a special Purpose Vehicle, SPV. The SPV actually owns the asset (the building) on behalf of the company and leases it back to the company. So, instead of buying the building outright, which would cause a large, covenant triggering liability (the building’s purchase price) on the balance sheet, it enters into an ‘operating lease’ off balance sheet and records just the small operating expense (lease payments). This method also maintains liquidity for the company. It seems as if this would be illegal, but it’s not.

Off Balance Sheet Financing

Off-balance sheet financing is discretionary and the activity is not required to be reported on the balance sheet. Typical items held off the balance sheet include operating leases, joint ventures and partnerships. Often, an analyst must locate these items which tend to be buried in the footnotes in the company’s financial statements. But the footnotes may not actually list the financing arrangements directly; they may simply indicate the ability to pursue future financings.

Infamous Off Balance Sheet frauds

Even though off-balance sheet items are not required to be reported on the balance sheet, the vast majority of items are legitimate. The problem arises when off-balance sheet items involves dealings with questionable entities, such as offshore subsidiaries (i.e. ‘partnerships’).1

Even though off-balance sheet items are not required to be reported on the balance sheet, the vast majority of items are legitimate. The problem arises when off-balance sheet items involves dealings with questionable entities, such as offshore subsidiaries (i.e. ‘partnerships’).1

For example, liabilities of a subsidiary are not required to be listed in the financial statements of the parent company. As such, liabilities can be easily transferred from the balance sheet to a largely hidden subsidiary. This was at the heart of arguably the biggest off-balance sheet scandal of all time-Enron.

Enron

In Enron’s case, it created SPVs which were created for the purpose of hiding debt. Enron would also capitalize, fund, its SPVs with its own stock. It’s death blow was that it guaranteed the value of the SPVs and when the stock turned south, so did the value of all SPVs.2

Further, these SPVs had clear conflicts of interest (Enron executives were principles in the vehicles) and therefore were not operated as arms-length transactions.3 Again, no one seemed to know the extent of the gimmickry because the SPVs were unconsolidated subsidiaries whose actions weren’t being fully reported.4

Lehman Brothers

Off-balance sheet financing also played a significant role in the Lehman Brothers bankruptcy. Through the use of off-balance sheet entity ‘Repo 105’, Lehman was able to move $50 billion of debt off of their balance sheet, making them appear more financially stable before a quarter’s end.5 Since it was classified as a repurchase agreement, it was ‘bought back’ after the reporting period. To make matters worse, when the debt was originally moved off-balance sheet, the bank recorded the debt as a ‘sale’ and booked the $50 billion as revenue!6 This type of accounting shenanigans contributed to the largest bankruptcy in U.S. history, wiping out the life savings of thousands of employees of the bank.

To make matters worse, when the debt was originally moved off-balance sheet, the bank recorded the debt as a ‘sale’ and booked the $50 billion as revenue!6

Today, accountants, auditors and analysts are increasingly trained to check the footnotes on these accounts. Further, the implementation of Sarbanes-Oxley made corporate directors criminally liable for lying on financial reports. While an improvement, the regulations are unlikely to catch all fraud. And the training if often lacking.

These scandals inevitably cost financial firms money through fines and penalties. For example, JP Morgan was fined $135 million for its role in the Enron fraud.7 Today, compliance personnel are quite busy at financial firms, managing risk whenever possible. Risk managers are some of the most highly recruited careers in finance today.

Consider an Online Masters in Financial Crime and Compliance Management Degree

There are a dedicated group of financial professionals that are committed to detecting, preventing and catching accounting and financial fraud. Forensic accountants and fraud investigators decipher off-balance sheet transactions when following a money trail, looking to catch an employee who has committed, and is hiding, a financial crime. With the global nature of business today, following money trails through a web of subsidiaries and off shore entities is a daunting task.

But if you’re up for the challenge, consider furthering your career with an online Masters in Financial Crime and Compliance Management Degree. These programs are designed to teach the student many of the tools needed to detect and deter financial crimes-in other words, catch fraudsters!

 

1,4,5,6http://www.newlearner.com/courses/hts/bat4m/pdf/Exploring%20Off-Balance%20Sheet%20Accounting.pdf
2,3http://www.investopedia.com/ask/answers/060815/how-did-enron-use-offbalancesheet-items-hide-huge-debts-and-toxic-assets.asp
7http://www.economist.com/node/2374354

 

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Financial Statement Fraud: Off Balance Sheet
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Financial Statement Fraud: Off Balance Sheet
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Sometimes, companies execute transactions not recorded on any financial statement. These ‘off-balance sheet (OBS)” items are assets or liabilities that exist, but are not required by IFRS to be included on financial statements (balance sheet).
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