Off balance sheet entities are set up by many companies for different reasons and often involve a set of highly complicated transactions. The reasons for their existence vary from planning to save taxes to avoiding honest and transparent disclosure of financial information (as in the case of Enron). If you have to understand how these work, you will need to have a basic understanding of balance sheets. The balance sheet is the statement of financial affairs of the company and includes a full account of all company assets and liabilities as well as the shareholders equity (which is also called net worth).
Prospective investors use the balance sheet of the company to establish its financial condition and its health. In theory, in accordance with the demands of financial and accounting regulation, the balance sheet provides an honest and transparent look at the state of affairs of the company and is a reliable document for evaluation. The investor is also able to compare the position with that of the competition or similar companies which may be used as a benchmark to see if it matches up favorably. Naturally the more the excess of assets over liabilities, the higher will be the net worth and the stronger the position of the company.
In financial theory, an off balance sheet entity as an entity that is set up to hold either assets or liabilities of a company and not be required to be reported on the company’s own balance sheet. To give you an example, because the oil exploration business is a high risk business, oil companies will often set up off-balance-sheet entities to finance individual oil exploration projects. This means that the debt raised in these off-balance-sheet companies do not appear on the parent company balance sheet. As a result even if the project fails, it does not impair the health of the parent company balance sheet. Another example is where the company spins off business or an operating unit into another company with the intention of selling it. The advantages are that the company receives cash for the sale and transfers the risk of the business being sold to a set of new investors.
The above are honest and legitimate uses of off-balance-sheet entities but, sadly, they are often misused for more dubious purposes. They can sometimes be used to inflate profits of the parent company and make it look more profitable than it actually is. They can also be used to hide debt by using complex financial instruments such as credit default swaps to transfer debt to the off balance sheet entity. The balance sheet of the parent will not therefore disclose its true financial obligations and the balance sheet will as a result look healthier.
The prolonged and extensive misuse first came to light when the Enron scandal surfaced and the company collapsed leaving millions of investors in the lurch. For instance, the company would build a power generation plant and immediately book the projected profit on the project even though not one cent had started coming in. If the true earning from the power plant was less than the projected earnings, the company would not book the loss but instead transfer the asset to an off-balance-sheet entity which was not required to report the loss to the shareholders of Enron.