Companies have used off balance sheet entities responsibly, and irresponsibly, for some time. These separate legal entities were permissible under GAAP and tax laws so that companies could finance business ventures by transferring the risk from the parent to the off balance sheet subsidiary. Today, a company that has any kind of off balance sheet item is being tarnished by Enron-gate, whether justified or not. This article will define some typical off balance sheet items and discuss whether they are "good" or "bad."
The term "off balance sheet" can refer to many things. Typically, it refers to separate legal entities (separate companies where the parent holds less than 100% ownership) or contingent liabilities such as Letters of Credit or loans to separate legal entities that are guaranteed by the parent. GAAP allows these items to be excluded from the parent's financial statements but usually they must be described in footnotes.
The Good
Off balance sheet companies were created to help finance new ventures. Theoretically, these separate companies were used to transfer the risk of the new venture from the parent to the separate company as a way to finance the new venture without diluting existing shareholders or adding to the parent's debt burden. Sometimes the separate companies were created to pursue a business project that was a part of the parent's main line of business. Other times these separate companies were created to house business that were decidedly different from the parent's line of work (in order to unlock "value"). These separate legal entities could be privately held partnerships or publicly traded spin-offs.
For example, oil-drilling companies established off balance sheet subsidiaries as a way to finance oil exploration projects. These subsidiaries were jointly funded by the parent and outside investors who were willing to take the exploration risk. The parent company could have sold shares or borrowed the money directly, but the accounting and tax laws were written to allow these projects to be funded this way so as to appeal to investors who wanted to invest in specific explorations rather than investing in the parent company.
Sometimes these separate legal entities are created to "house" a business that was significantly different from the parent's core business. For example, Williams Cos., created Williams Communications to pursue the communications business. Williams Companies spun off Williams Communications, but the bankers required the parent to guarantee the debt of Williams Communications. This is not an unusual request because Williams Communications was a new company.
This use of off balance sheet entities is good in that it transfers risk from the parent's shareholders to others that were willing to take the business risk. Investors in Williams Companies (an energy resource company) may not have wanted to invest in a communications company, so management created a separate entity to house that business. Likewise, oil companies have used off balance sheet entities to remove the exploration risk from their business in order to share it with others that wanted a bigger piece of the potential return from exploration.
The Bad
While GAAP and tax laws were created to allow off balance sheet entities for the valid reasons noted above, bad things happen when economic reality differs significantly from assumptions that were used to justify the off balance sheet entity. Problems also occur when egos get too big.
In Williams' case, the decision to spin off the communications business was reasonable at the time. The parent had the infrastructure on which to build a communications network, but it was an energy company. By spinning off the subsidiary, it was not forcing its investors to take on the risk of a communications company and it was able to take advantage of the market's demand for communication stocks. Likewise, the need to guarantee the debt of a new subsidiary is a reasonable request that bankers make in this type of transaction.
What went "wrong:" was that economic reality differed from the assumptions that were used to justify the spin off. Dotcom mania resulted in over capacity that is causing problems for all telecommunications companies. The loan guarantee, which is usually never expected to be triggered, is now an issue due to the recession and the slump in the telecommunications sector.
Another factor that causes troubles is ego. Enron currently exemplifies ego as the basis for the misuse of off balance sheet items. Here, off balance sheet vehicles appear to have been used to pump up financial results rather then for legitimate business purposes. What started as a plan to legitimately use off balance sheet vehicles morphed into ways to manufacture earnings as trades went bad. While one could argue that this is also a case where economic reality differed from expectations, the way management reacted to the situation allows us to classify it as an ego thing.
This financial engineering is usually fueled by the need to reach certain operating targets established by Wall Street or compensation plans. Once management succumbs to this "Dark Side," more time is spent on trying to game the system than trying to manage the core business. Then it is only a matter of time before the house of cards falls.
The Ugly
It gets ugly when the markets start to punish a stock just because it has an off balance sheet item. Granted, it not always easy to read a company's SEC filings, let alone dig into the footnotes and figure out how the off balance sheet items might impact results. But the companies that provide full disclosure will probably be the better investments.
Conclusion
The loss of faith in accounting's ability to provide full disclosure could have a bigger impact on the stock market than the events of September 11th. The Attacks were an exogenous factor and we bounced back nicely. The loss of confidence in financial statements is an attack on one of the core elements of investment decision making. To paraphrase Johnny Cochran, "If the statements aren't true, what will we do?"
However, the focus on off balance sheet accounting will have two major benefits.
First, it will result in new regulations that will hopefully prevent future "Enrons." Some of these changes should be:
• prevent officers of the parent from being officers of the off balance sheet subsidiary
• Increase the percentage ownership by outside and non-affiliated companies
• Enforce disclosure rules so that investors can clearly understand the risk (if any) posed by off balance sheet companies.
Second, the current market over-reaction is creating a buying opportunity. Markets always over react and there is panic in the Street today. Uncertainty created by the loss faith in financial disclosures could cause more damage to the market than September 11th did.
