Off-Balance-Sheet Financing

It’s like... money from a 4th dimension. Money is being borrowed. Stuff is being bought. But somehow, on the normally filed books and numbers and 10 Qs and Ks and other filings. It’s like that Doors song: “She’s not there.”

Companies want to show as little debt as possible on their books for a variety of reasons. Like they don't want to look vulnerable to their competitors if a big luscious jewel comes along that they can buy. They also want to pay the cheapest rent on their debt possible... and less debt means less risk in paying back the dough and that makes companies more profitable, and shareholders happier.

So when companies need things, they will actively look to find financially efficient ways of buying them.

Example.

Our friendly tractor smelting company needs a new factory. It can buy one for $100 million. Huge debt on its books. Risk. All kinds of other liabilities. If the company was sitting on a fat stack of a billion dollars that was burning a hole in its pocket. Then this might be a viable thing to do, but that last union strike cost a fortune, and the company and its creditors, are worried there might be another one, which would fully bankrupt the company and put everyone out of a job and make the debt loaned to the company fully bust.

So, what can they do instead? They need this factory...the old one is slowly but surely slipping into the muck surrounding the neighboring nuclear plant.

Well, one type of off balance sheet financing comes from leasing. That is, the company could take out an operating lease on an already-existing tractor smelting factory that has been just sitting there, 10 miles down the road, a victim of the last union strike from a competitor which actually did bankrupt that company.

So the smelting factory is great and new ish, and is just waiting to be leased. And the banks that now own it would be only too delighted to lease it to the tractor smelting company. So, from an accounting perspective, there isn’t debt that appears on the balance sheet when they form an operating lease to take over the factory.

In essence, that lease is just rent. And appears as a normal, vanilla expense. It’s off balance sheet. It is, essentially, financing an operating asset without triggering debt covenants that make that long-term commitment to leasing the factory look like it is, in fact, legally dead.

Think about the way in which accounting is handled for a 5-year lease on a building. That lease covers 60 months at, say, 10 grand a month, or $600k worth of financial obligation, paid monthly. Legally, the company is inextricably bound to paying its rent for the entire duration of the lease. Is that money considered debt? Well, in this case, no.

But it’s not far from being treated as an off balance sheet event, and, in practice, conservative companies actually put a line for lease obligations as one of their most current and long-term sets of liabilities.

"Alex, Enron for $1,000…"

So yes, if you don’t remember because you were still in the womb doing the backstroke, Enron was one of the great off balance sheet fraudulent chicanery exercises in American business history. The company deployed some of the most evilly clever accounting practices in history to hide the fact that it, in fact, owed massive debt obligations, which were buried as being “off balance sheet assets”.

How did they pull off this magic? The shell game revolved largely around sometimes real and often fake partnerships, where Enron could choose at will to be viewed either as a majority or minority participant such that, with smoke and mirrors, it could make it appear as if it owned the debt liability. And more often than not, the debt liability was, in fact, owed by its shill partners.

The precept in not reporting the real numbers came from the ability to call the debt liabilities “off balance sheet.” The perception was that the company had an asset that was growing quickly, but in fact, the company was borrowing a dollar to buy 50 cents of notional revenue.

The bottom line: off balance sheet transactions are only so far off. And the long arm of the law and the collection agency guys with the baseball bats reach into all kinds of nooks and crannies around the globe. And yeah, the guy orchestrating this whole dance...he's doing backstroke in the morgue now. Short neck; long rope.