Off Balance Sheet Accounting

Off residue primary(prenominal)sheet finance is financing from sources early(a) than debt or equity glumerings, such as joint ventures, research and study partnership and operate leases. For complex institutions such as banks, they increase their drug abuse of off shore subsidiaries and swap transactions to avoid disclosing liabilities. In other(a) words, off counterpoise sheet accounting is a process which a business creates what is practically a debt that it must pay off, precisely the debt is accounted as another type of transaction that does not count as a liability. Similarly, this applies to addition likewise.Operating leasing is the most common form of off remnant sheet financing. With leasing, on the one hand, an entity could acquire the upright to use an asset through a rental agreement. On the other hand, the entity could get the same asset using external finance. While the two positions may result in identical net cash flows to the entity, in the case of a buy both the asset and the associated financing liability appear on the entitys balance sheet whereas in the formal scenario rental payments atomic number 18 accounted for as a period disbursement, with the asset corresponding liability omitted from the entitys balance sheet.Entities used Special Purpose Entities (SPE), are also known as Variable Interest Entities (VIE) for off balance sheet treatment of deals. SPE or VIE is a corporation or partnership formed for the pop the question of borrowing money to buy fiscal assets. Debts are move to a newly created fraternity (SPE OR VIE) specifically to derive a company look like it has far less debt than it actually does, which was the case with Enron. For example, a company needs to finance a business venture still doesnt want to take on the risk, or when there is too much debt to get a loan.By starting a new SPE, they arsehole secure a loan through the new entity. There are situations where it makes sense to start a SPE. If a company wants to branch fall out into another area outside of its core business, a SPE will musical accompaniment that risk from affecting the main balance sheet and profitability of the company. The main factor that companies are doing off balance sheet accounting is to give up a split looking balance sheet with subvert report debt to equity ratio, which usually results in driving their stock price higher. Nevertheless, negligence of the asset could help to inflate return on assets.This may make the firms look more(prenominal)(prenominal) creditworthy. For instance, by having operating leases, debt does not appear thus, trim pecuniary leverage with an increase in operating leverage. By having lower leverage ratio or higher operating leverage, it could attract more investments from investors therefore, it drives up the stock prices. Next, off balance sheet accounting allows the firms to give birth benefits of the interest deduction for tax purposes while avoiding the o bligation and the interest expense on its financial statements.In other words, firms with off balance sheet financing are likely to be in possession of tax interest expense that exceeds financial reporting interest expense. However, off balance sheet accounting has brought about impacts toward the stakeholders. Off balance sheet accounting removes the transparency from investors, foodstuffs and regulators. Firms use financial engineering to make their balance sheet appear that they are better capitalized and less risky than they really are. Without transparency, investors and regulators can no longer accurately assess risks.This is because investors and regulators use the balance sheet as an anchor in their assessment of risk. The shareholders could only guess at the extent of the firms exposure risks. This affects the judgment of stakeholders and, it could bring tremendous loss to the stakeholders when the firms collapse. The Enron accounting put-on will best illustrate this. I n order to overcome this issue, regulators have established several methods through Sarbanes-Oxley Act, MD&A as puff up as new rules on leasing.The Securities and Exchange Commission issues final rules implementing instalment 401(a) of the Act relating to the apocalypse of off balance sheet arrangement, contractual obligation and contingent liabilities. These rules require disclosure of off balance sheet arrangement that have, or are reasonably likely to have, a current or future effect on a companys condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.The disclosure includes elements such as the nature and business purposes to the company of the off balance sheet arrangement and the importance to the reporting company of the liquidity, capital resources, market risk support, credit risk support or other benefits provided by the arrangement. Nonetheless, firms are to disclose the amounts of revenues, expenses and cash flows of the company arising from the arrangements as well as the nature and amounts of interest retained, securities issued and other debt incurred by the company in fraternity with the arrangements.The rules also require public companies to disclose in a tabular format in their MD&A the amounts of payments due under stipulate contractual obligations, aggregated by category of contractual obligation. The five categories of contractual obligations, consisting of long term debt obligations, capital lease obligations, operating lease obligations, purchase obligations and other long term debt liabilities reflected on the companys balance sheet. The table must disclose what portion of payments under these obligations is due in spite of appearance less than one year, from one to three old age, from three to five years and more than five years.To encourage the disclosure on off balance sheet arrangement, the amended rules include a safe declare that applies the active statutory safe defends protecting forward-looking information required by the rules. With regard to the disclosure of off balance sheet arrangements, the safe harbor provision indicates that the meaningful cautionary statements element of the statutory safe harbor will be satisfied if the company satisfies all the requirements of the amended rules relating to off balance sheet disclosures.As mentioned above, operating leases can be exploited by entities for off-balance sheet financing using an operating lease to obtain assets, thereby not increasing leverage and not decreasing return on assets. The proposed new standard on leases by the joint project of FASB and IASB, presently under development, moves away from the current risk and returns basis to a right of use basis. The lessee and the lessor will recognize assets and liabilities individually for all rights and obligations arising from a lease contract.There will no longer be separate treatments for operating and finance leases all leases will be accounted for on the same basis. In short, operating leasing contract is no longer available and only finance leasing will be used for accounting in the near future. In short, off balance sheet accounting could be use but only with appropriate disclosures are done. By having the disclosures, balance sheet is more transparent to the stakeholders and, the stakeholders do not need to have a barbarian guess on the risk of a company. Stakeholders investments are said to be more secured.