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Off balance sheet financing generally refers to financing from activities not on a corporate balance sheet. This could include operating leases, joint ventures, and research and development partnerships. Businesses will keep these larger capital expenditures off the balance sheet by classifying them in a way that keeps debt-to-equity and leverage ratios low. This is especially true if negative debt covenants would be broken by including the large expenditures on the balance sheet.
Off balance sheet financing items (most commonly operating leases) must follow Generally Accepted Accounting Principles (GAAP), in determining whether a lease should be expensed or capitalized. If expensed, the leased asset remains on the lessor’s balance sheet, and the lessee only expenses the actual rental charge of the asset.
Many US corporations have structured subsidiaries and partnerships to prevent billions of dollars in debt from appearing on their balance sheets. Various banks arrange many of these structures and use them as well. Off balance sheet financing became popularly known during Enron Corporation’s bankruptcy travails in 2002. Many of the company’s financial problems were a result of questionable accounting practices in relation to off balance sheet entities. Since Enron’s failure, this type of financing is becoming more scrutinized by government entities.