Off-balance sheet financing has been a relatively popular financial term in recent years. Many leading real estate companies have tried off-balance sheet financing and have made off-balance sheet financing a daily assessment task for their investment and financing departments. Let’s first talk about the concept of financing. In the eyes of many people, financing is the process of raising funds from financial institutions and repaying principal and interest on schedule. This is everyone’s stereotype about financing.
This understanding is correct, but it is only a narrow financing concept. Financing in a broad sense refers to all activities in which enterprises raise funds from outside. As far as the real estate industry is concerned, early recovery of the purchase money, advance funds to the general contractor, deferred payment of accounts payable, borrowing from cooperative units, etc. all fall into the category of financing.
What Is Off-Balance Sheet Financing?
Off-balance-sheet financing, referred to as off-balance sheet financing, off-book financing, off-balance sheet financing, off-balance sheet financing.
(Narrow sense) Financing of leases that do not meet all the conditions of a capital (financing) lease, so that the present value of the promised payment amount is not recognized as a liability (nor an asset), and is not reflected in the balance sheet or notes. A term used primarily by professionals in the finance and accounting fields (see “Operating Leases”). Off-balance sheet financing is also used in some debt-financed operating leases. The provider of funds has no recourse against the lessor and can only ask the lessee to use the leased assets to recover the loan to the lessor.
(Broadly speaking) Off-balance sheet financing generally refers to all financing behaviors that are not included in the balance sheet and have a significant impact on the company’s operating results, financial status, and cash flow.
Characteristics of Off-Balance Sheet Financing
- Confidentiality: The assets and potential liabilities formed by off-balance sheet financing do not need to be recognized and reflected in the balance sheet, which means that the true financial status of the company cannot be reflected in the balance sheet.
- Flexibility, off-balance sheet financing has relatively low requirements on corporate asset size and other aspects, which also greatly enhances the flexibility of financing channels.
- Risky, since off-balance sheet financing hides the true assets and liabilities of the company, the financial statements issued by it are relatively deceptive.
Ways to Realize Off-Balance Sheet Financing
Off-balance sheet direct financing. A special form of borrowing that does not transfer ownership of the asset. For example, business activities such as operating leasing, consignment sales, and processing of supplied materials do not involve the transfer and flow of asset ownership and do not need to be reflected in the financial statements in accounting. However, the right to use the assets has indeed been transferred to the financing enterprise, which can meet the needs of enterprises to expand their business scale.
Off-balance sheet indirect financing is a financing method in which another enterprise replaces the liabilities of the enterprise. The most common is to establish an affiliate or subsidiary and invest in the affiliate or subsidiary, or to replace the liabilities of the parent company with the liabilities of the affiliate or subsidiary.
Off-balance sheet transfer of liabilities means that financing enterprises transfer liabilities from on-balance sheet to off-balance sheet. This transfer can be achieved by discounting notes receivable, selling receivables, and entering into product financing agreements. In fact, due to the nature of mortgage loans of accounts receivable, the liabilities are transferred off the balance sheet due to accounting processing reasons. Off-balance sheet financing is mainly debt financing. Its positive role is to enable companies to increase financial leverage. Especially when financial leverage is limited within the balance sheet, off-balance sheet financing can be used to amplify financial leverage and increase equity capital profits. At the same time, financing channels are opened up to increase financing methods. Especially when on-balance sheet debt methods are limited and channels are not available, financing purposes can be achieved through off-balance sheet financing.
The Impact of Off-Balance Sheet Financing
An important means of off-balance sheet financing is to design some complex economic businesses, making it difficult for statement users to judge the impact of this business on corporate assets or liabilities. This type of complex business has the following characteristics:
- Separate the legal ownership of a certain project from the ability to enjoy the main benefits related to it and bear important risks.
- One transaction is intertwined with one or more other transactions, and it is difficult to understand the economic impact of the business without analyzing them together.
- The terms of the transaction contain one or more options or conditions, and it can be reasonably inferred from these terms that the enterprise will exercise the options or the conditions will be met. Forward contracts are sometimes used as a means of off-balance sheet financing. Commodity consignment, factoring of debts, securitized mortgages, and loan transfers may all lead to off-balance sheet financing activities.
The Impact of Off-Balance Sheet Financing on Corporate Financial Status
The impact of off-balance sheet direct financing on financial status
Direct off-balance sheet financing refers to a form of direct financing in which asset ownership is not transferred and the financing enterprise enjoys the right to use the assets which is reflected in the balance sheet. Because the financing enterprise owns the assets, the enterprise is not recognized as an asset or liability. After a financing enterprise obtains the right to use assets, it will not only be able to obtain funds but will not change the solvency reflected in the balance sheet. For example, operating leases, when the lessee leases equipment for a period shorter than the equipment’s useful life, can reduce the company’s capital holdings and the intangible wear and tear of the equipment, thereby increasing equipment utilization. The use of off-balance sheet financing such as operating leases is beneficial to the company’s long-term development and the interests of investors.
The impact of off-balance sheet indirect financing on financial status
Indirect off-balance sheet financing refers to replacing the company’s liabilities with the liabilities of another company to maintain the liabilities on the company’s balance sheet within a reasonable range. This off-balance sheet financing method can not only meet the company’s capital needs but also control the company’s liabilities within a reasonable range, paving the way for the company’s subsequent financing activities. The most common form of indirect off-balance sheet financing is for a parent company to invest part of its assets in a subsidiary. The reduction in the parent’s investment assets in the subsidiary will be supplemented by an increase in long-term investments. Financing is easier through subsidiaries. A parent company can operate through the liabilities of its subsidiaries. The liabilities of the subsidiary are the liabilities of the parent company.
Conclusion
It is worth mentioning that various countries have made a relatively strict distinction between financial leases and operating leases and stipulated the conditions for financial leases. If a lease meets one of the conditions, it should be treated as a finance lease and recognized as an asset and corresponding liability by the lessee to reduce off-balance sheet financing. These conditions are based on the economic substance of the business.
It is also stipulated that assets and liabilities may not offset each other. Enterprises also need to make appropriate disclosures about these complex businesses, especially items that have been recognized in the financial statements that are different from ordinary assets and liabilities in some aspects, as well as items that have not been recognized in the financial statements, to ensure that they are true and accurate.