When a business seeks outside capital for major projects, this transaction will result in a liability being reported on the company’s balance sheet. In order to maintain a solid balance sheet to outside reviewers, companies will sometimes seek outside investment sources that result in off-balance sheet financing.
Several options are available for this type of financing.
Balance sheet financing refers to the process businesses use when adding capital for major investment projects or product development. Most major companies do not use capital gained through daily operations because they wish to avoid a negative cash flow. In order to finance major undertakings, businesses will find outside financing for these projects, which usually result in a liability reported on the company’s balance sheet. However, some options allow for financing that is not reported on the balance sheet, creating better financial ratios for the business through asset/liability management.
Traditional balance sheet financing for business are debt or equity financing. Most privately-held businesses use debt to finance their major projects, resulting in a liability reported on their balance sheet. Publicly-held companies can issue stock or bonds for financing purposes, resulting in higher stockholders equity or long-term debt liability reported on their balance sheet. Public companies can also negotiate long-term financing through banks or investment firms, which also results in a reportable liability.
Off-balance sheet financing usually falls under one of the following categories: joint venture, research and development agreements, or operating leases.
These types of financing agreements are quite popular in business because they allow for firms to combine resources on major financial projects. Here is a brief description of each type of agreement:
Joint Venture: this agreement usually states one company will finance the project while the second completes the development or production process.
Research & Development: this agreement allows sharing the burden on R&D expenses, thereby eliminating full financial liability on one company.
Operating Lease: this agreement lets a company simply report the expense of using property or equipment, rather than a capital lease which means the company must report the full financial liability for equipment used in major projects.
Special Purpose Entities
A special purpose entity (SPE) is a legally-created business formed for the purpose of maintaining assets and liabilities for certain business-related investments. Under general accounting rules, if a firm wholly owns the SPE, all assets and liabilities from the SPE are reported on the main company’s balance sheet. SPEs are most famously remembered as the tool used by Enron to hide their massive losses from company shareholders. Through illegitimate means Enron shifted debt to their SPEs in hopes of maintaining the company’s good name; during an audit Enron was made to consolidate their SPE financial statements into the main company’s financials, severely crippling Enron’s financial status.
When using an SPE for legitimate business purposes, companies must maintain a certain distance of ownership to ensure that all transactions with the SPE are considered “arms-length.” Two general rules must apply for SPE transactions to be considered arms-length: An owner independent of the main company must invest 3 percent into the SPE at full risk and the independent owner must maintain control of the SPE. Failure to follow these basic rules will usually result in the SPE being considered a company subsidiary, with all assets and liabilities fully reportable on the main company’s financial statements.