Off-balance sheet entities are assets or liabilities that do not appear on the company’s balance sheet. Investors use the balance sheet to understand the company’s assets and liabilities and assess its financial status. Since assets are better than liabilities, the company wants more assets and fewer liabilities on its balance sheet. Some people place their obligations in off-balance sheet entities.
Understanding off-table entities
Off-balance sheet entities allow companies to remove assets or liabilities from the balance sheet. For example, oil drilling companies often establish off-balance sheet subsidiaries as a way of financing oil exploration projects.
The parent company can set up a subsidiary and split it by selling a controlling interest (or the entire company) to investors. The sale will create profits for the parent company and at the same time transfer the potential risk of new business failure to investors. After the transaction is completed, the subsidiary will no longer appear on the balance sheet of the parent company.
Danger of off-balance sheet entities
Off-balance sheet entities can be used to artificially exaggerate profits and make the company look financially safer than it actually is.
A series of complicated and confusing investment tools—Including but not limited to mortgage debt, subprime mortgage securities and credit default swaps—Used to remove debt from the company’s balance sheet. The parent company listed the proceeds from the sale of these projects as assets, but did not include the subsequent financial obligations as liabilities.
For example, consider a loan provided by a bank. When disbursed, the loan is usually kept as an asset in the bank’s books of account. If these loans are securitized and sold as investments, the securitized debt (of which the bank is responsible) will not remain in the bank’s books.
This accounting practice helps the issuing company’s stock prices and artificially inflates profits, enabling the CEO to claim a sound balance sheet and earn huge bonuses for them.
History of fraud
The Enron scandal was one of the first developments that brought the use of off-balance sheet entities to public attention.
In Enron’s case, the company will build an asset, such as a power plant, and immediately declare its estimated profit on its books, even if it does not make a dime from it. If the power plant’s revenue is less than the estimated amount, the company will not bear the loss, but will transfer these assets to the off-book company, where the loss will not be reported.
The entire banking industry participates in the same practice, usually through the use of credit default swaps (CDS). According to data from the International Swaps and Derivatives Association, this practice is so common that only 10 years after JP Morgan Chase launched CDS in 1997, its business has grown to approximately US$45 trillion.
This is more than twice the size of the US stock market, but this is just the beginning. Later, it was reported that the CDS market was worth more than 60 trillion U.S. dollars.
The use of leverage further complicates the main body of off-balance sheet entities. Consider a bank with $1,000 to invest. This money can be invested in 10 stocks priced at $100 per share. Alternatively, the bank could invest $1,000 in five options contracts, giving it control over 500 shares instead of just 10 shares. If the stock price rises, this approach will be very beneficial, if the stock price falls, it will be catastrophic.
Now, apply this situation to banks and their use of CDS tools during the credit crisis, remembering that some companies have leverage ratios of 30 to 1.
When their bets failed, American taxpayers had to rescue these companies to prevent them from going bankrupt. The financial masters who failed to plan retained their profits.
The future of off-balance sheet entities
Attempts to restrict the use of off-balance sheet entities are included in the Sarbanes-Oxley Act, which obliges listed companies to provide evidence of the accuracy of financial reports in annual audits.
As part of this law, since 2003, public companies have been required to report all off-balance sheet arrangements to the U.S. Securities and Exchange Commission (SEC) in their quarterly and annual financial reports.
Efforts to change accounting rules and pass legislation to restrict the use of off-balance sheet entities have not changed the fact that companies still want to show more assets and fewer liabilities on the balance sheet.
With this in mind, they continue to look for ways to circumvent the rules. Legislation may reduce the number of entities that do not appear on the balance sheet, but loopholes will continue to exist.