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To investors, Enron appeared strong and prosperous. However, what was hiding outside of their financial statements would lead to one of the largest scandals in Wall Street history. Chief Financial Officer, Andrew Fastow, argued a clever twist of the rules prior to being handed a six year prison sentence. By the end of 2001, everyone was left wondering what had just happened.
Although Enron’s manipulation was deemed illegal, many publicly traded companies partake in similar methods without raising concern from regulators. It is an accounting practice commonly known as off-balance-sheet activity.
Let’s get into what off-balance-sheet activity is and how it is used.
What is Off-Balance-Sheet Activity?
Every balance sheet is made up of three categories — assets, liabilities, and equity. The statement in considered balanced when the total assets equals the sum of total liabilities and total equity. In an attempt to create this equal weighting, companies are allowed to leave some forms of assets or liabilities off the balance sheet. This is considered off-balance-sheet activity.
As value investors we often consider multiple ratios when analyzing a stock for purchase. One of the most popular is the debt/equity ratio. Using the figures provided on the balance sheet, we divide the total liabilities by total shareholder equity.
Ratios such as debt/equity can become inaccurate if off-balance-sheet liabilities are not included in the calculation. This can be distressing for investors, but is a major advantage from the company’s point of view. In fact, some managements use off-balance-sheet activity to their benefit.
Say for example the company is in need of a loan. However, their lender is unwilling to provide the financing as it will push their debt/equity ratio above an undesirable and risky level. Using legal methods, management can move debt off the financial statements, making room for new leverage.
There are many different types of off-balance-sheet assets and liabilities. There are also sectors that are known to have companies with greater off-balance-sheet activity. Investors should know where and what to look for prior to making an investment.
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How is That Even Legal?
At this point you’re probably wondering how off-balance-sheet activity is even legal. It is a great question and deserves an explanation.
Depending on which country the company operates within, they will have a set of accounting standards they must uphold. In America, the Securities and Exchange Commission requires all publicly traded companies to follow Generally Accepted Accounting Principles (GAAP), whereas countries such as Canada, China, United Kingdom, and Germany all follow International Financial Reporting Standards (IFRS). GAAP and IFRS will outline how a company must partake in off-balance-sheet activity. These specifics are beyond this article’s scope but can be found online and in various textbooks.
There’s good news and bad news when it comes to off-balance-sheet accounting principles. The good news is that off-balance-sheet does not necessarily mean out of sight. Investors should be able to find information about the extra assets or liabilities in the financial statement’s footnotes. The bad news is that the footnotes are often very complicated and difficult to understand. Remember, highly educated accountants are creating these statements and they are sure not trying to help investors understand everything.
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It may appear that off-balance-sheet activity is a deceptive tactic used by untrustworthy management, however this is not always the case. Its legal intent is to protect investors from risk. For example, a company may be pursuing a new venture to expand their operations. Since this is typically a risky move, they can create a separate entity, leave it off the balance sheet, and remove liability from shareholders. In doing so, they’ll keep debt levels down and preserve equity.
Unfortunately, off-balance-sheet activity is not always used to benefit investors. In the case of Enron, large amounts of financing were held off their balance sheet and minimal information was disclosed in the footnotes. Only the smartest investors were able to dissect exactly what it meant. It also didn’t help that they overstated totals, made false statements, traded on insider information, and committed various other types of fraud.
Common Types of Off-Balance-Sheet Assets
As previously mentioned, off-balance-sheet activity can come in two forms. In this section we’ll discuss assets. Any resource with economic value and the potential for benefits in the future is considered an asset. They can always be found in the top half of the company’s balance sheet.
One of the most popular types of off-balance-sheet assets is operating leases. When you lease a new car, you pay the dealership a fee in exchange for control over the vehicle. Technically, the dealership remains the owner of the car/asset. However, if they were to have a balance sheet, the car’s value would be left off the asset section because they do not have control over it. The payments they receive would then be added to the income statement. Publicly traded companies do this as well with assets they lease to other companies.
You may be familiar with a company’s decision to spin-off part of their operations. The parent company creates a subsidiary and will often transfer some assets to them. This could include land, property, equipment, or inventory. These assets will become part of the new entity’s balance, but since they are owned by a larger organization, the parent company is able to list the asset off the statement.
Common Types of Off-Balance-Sheet Liabilities
On a balance sheet, directly below assets, will be liabilities. These are anything that obligates the company to sacrifice a resource at some point in the future. A common type of liability a company will have is debt–both long-term and short-term. Management is more likely to keep liabilities off the balance rather than assets. This is because liabilities are considered a detriment to a company’s operations and they hinder ratios such as debt/equity.
Enron became famous for their off-balance-sheet liabilities after the scandal was revealed. Their main form of hidden obligations was partnerships with other companies. What we now know is that Enron created special purpose vehicles and formed partnerships with the new subsidiaries. Enron pushed millions of dollars’ worth of debt onto the new entities, clearing their own balance sheet. Without knowing about these partnerships–as most didn’t–Enron would appear like a low financed company. This was obviously not the case.
Instead of leasing that new car, you decide to get a loan to purchase it outright. Unfortunately, the dealership decides you don’t have a reliable credit history and someone must co-sign the loan on your behalf. You best friend decides to assume this risk and sign the contract. By doing so, your friend has obligated herself to a contingent liability. If you default, she now must pay the remaining balance. Companies can also obligate themselves to contingent liabilities. When the total amount that may be owed is unknown, the liability remains off the balance sheet.
Many publicly traded companies provide their employees with pensions when they retire or are no longer working. These recurring payments are owed by the company. Some will systematically set aside cash to build a reserve and make the pension payments. Others decide to pay their former employees with current income generated from operations. The former would be considered an unfunded pension liability and is often left off the balance sheet.
An operating lease can be either an asset or a liability–depending which side of the contract you are on. As mentioned earlier, when the company owns the resource and is leasing it, they have an asset. On the flip side, when the company is leasing the resource, they have acquired a liability. Both sides can leave their position off the balance sheet.
The airline sector is well known for off-balance-sheet liabilities–specifically operating leases. This is because their operations require expensive equipment such as aircrafts, engines, ground facilities, and terminal space.
After the Enron scandal shocked the world, changes to off-balance-sheet activity needed to be made. The Security Exchange Commission and the International Financial Reporting Board are working together to ensure investors are receiving full disclosure.
Still, we need to keep an eye out for hidden assets or liabilities. They could mean the difference between a strong and weak investment.
About The Author:
Colin Richardson is an intelligent investor, contrarian, and student of the world. His personal philosophy is to base reasoning not on speculation but rather on back tested systems and confirmation. Although he successfully completed the Canadian Securities Course certification, majority of his financial knowledge is self-taught. When not writing, he monitors a quantitative deep value stock portfolio.