Off Balance Sheet Financing Practices Essay Example for Free

Off Balance Sheet Financing Practices Essay OBSF is most of the times used by business enterprises to maintain their leverage or gearing positions in such a way which would not have any negative implications on the company. In the business world of today, OBSF is recognized as an important means for raising finance by means of operating leases, joint venture and collaborations with respect to Ramp;D. Following Off Balance Sheet Financing method results in significant variations in the overall financial reporting of an entity. Considering the changes in accounting and financial reporting requirements, it is generally expected that the companies using these technique will be more able to run their operations efficiently. However, keeping in view the case of off balance sheet financing and accounting in this respect, it is argued that while using OBSF companies are able to not disclose entirely the financing of their capital expenditures and thus the information required to be disclosed in this respect is not made available to the interested parties (Tyrrell 1986). This report discusses this area of accounting and explains how OBSF is actually promoted by the market economies and the expectations of increased profits from the companies. The usage of off balance sheet accounting and financing is not new. In the beginning of 20th century, this concept of managing a company’s balance sheet gained fame and the banking and other corporate sector applied this technique in their best possible interest with the main objective of keeping their balance sheets light weighted. Apart from a benefiting role played by the off balance sheet ccounting techniques, there are some serious consequences which are often associated with the application of this concept. As for instance, it is argued that among many other reasons, the practices of off balance financing and accounting also had a significant share in the recent financial downturn (Allen, et al. 2002). In this regard, Enron would be a good example to look upon. While striving for a healthy outlook o f Enron’s balance sheet, the management made use of special purpose entities with the objective of making large transactions which would not appear on the balance sheet of the company. This resulted in a healthy balance sheet outlook with huge of amounts of capital inflows but at the expense of nothing. However, this bubble of progress did not last long as the company’s stock prices started fluctuating sharply and consistently. These events created a sense of being not informed entirely about the company’s operations among the investors and after the Enron’s climax, the regulators jumped in with Sarbanes Oxley Act 2002. The Act was aimed at securing the investments of investors and introducing regulations with respect to corporate social responsibility. But these checks proved to be ineffective upon the emergence of the financial crisis in 2008 (Hall and Liedtka 2007). Increase in the global competition and more expectations from the investors and shareholders to maximize their value of investments are regarded as the driving forces in the market which influence management to improve the financial picture of a company. In addition, these expectations pose pressure on the management to find ways which may result in better presentation of the financial statements and improved earnings (Boot and Thakor 1991). The Banking sector in particular and other sectors in general are mostly seen following this approach. As for instance, there has been observed a trend of investing in such portfolios and instruments which are regarded as high risk investments. But the intention behind this is to improve or strictly stating ‘inflate’ the earnings of an enterprise without having regard to the riskiness of such investment decisions and the fact that the stakeholders of the business need justification of such improvements in the performance in the form of financial statements disclosures. For the purposes of obtaining security on the risky investments, corporations tend to enter into complex third party arrangements which cannot be disclosed in the financial statements. Apart from this, one other motivating factor which is regarded as the major reason behind this approach of management is that they have their own interests and objectives. As for instance, managers are better off in their performance appraisals when the company is showing profits consistently (Boone and Raman 2001). The practices of off balance sheet financing and accounting, as stated earlier, comprise of operating leases, joint venture and collaborations with respect to Ramp;D. Among these options, operating lease holds special importance and is given more consideration by the management due to the fact that they require minimum disclosures in the financial statements and are usually for a long term. Lease accounting is covered by IAS 17, SSAP 21 (UK) and FAS 13 (USA) (McGerty 2004, Lim, Mann and Mihov 2005). Prior to the formulation of these accounting standards, there were no obligations on the companies to disclose in their financial statements the future payments related to lease and therefore leasing was recognized as an off balance sheet financing technique. Apart from leasing techniques, there are various other methods being employed by different companies to move certain items off the balance sheet of the company. The use of off balance sheet techniques has been used to manipulate things. The most commonly used techniques to manipulate the financial information presented in the balance sheet of a company include swaps, variable interest entities (VIEs) and Special Purpose Entities (SPEs) (Ketz 2003). Although these tools have been used by companies around the world for different purposes which are mostly disclosed and transparent but the misuse of these tools has been also observed frequently by way of not disclosing the true facts. This practice has caused major setbacks to the global economy and also shattered the confidence of shareholders and investors (Hall and Liedtka 2007). As for instance, the collapse of Lehman Brothers is argued to have resulted due to off balance sheet approach followed by the company. In order to narrow down its balance sheet, Lehman Brothers moved its assets worth US dollar 50 billion from its balance sheet with the objective of portraying less amount of debt in the balance sheet (Rezny 2010). Keeping in view the above discussion and the facts stated related to the real world cases, it can be said that it is high time for the respective authorities to take measures in relation to this area of financial reporting. It is recommended that the governmental authorities and other financial reporting standards issuing bodies shall intervene appropriately through the right channels to ensure transparency in the financial reporting. Apart from this, the board of directors of corporations shall standardize the decision making processes and perform an effective oversight duty. In addition, it shall be made obligatory for business enterprises notwithstanding the sectors into which they fall, that every transaction shall be disclosed appropriately in the financial statements. Furthermore, the managers shall be motivated not pressurized to perform in the best interest of the organizations (Adams 1998). While concluding this report, it can be said that applying off balance sheet accounting and financing, whether for a good or evil purpose, has become necessary due to the increased expectations of the investors and shareholders related to the profitability of a business concern and also for the purposes of improving the financial statements overlook. Moreover, the lack of regulatory measures in this respect also has its share in promoting the adoption of this approach. Apart from this, it can also be stated that the benefits resulting from off balance sheet accounting are also considered as a means of attaining hidden objectives by managers which in turn motivates them to misuse the concept and benefit from the regulatory loopholes. For the purposes of addressing these issues, it is pertinent that the regulatory authorities who are responsible shall make such arrangements which may promote such financial reporting practices which are more representative of the facts. In addition to this, the disclosure requirements related to off balance sheet accounting and financing activities are required to be revisited.