With off-balance sheet accounting, a company didn't have to include certain assets and liabilities in its balance sheet -- it was "off-sheet" and therefore not part of their financial statements. We'll talk more later about how the Sarbanes-Oxley Act changed this practice. While there are legitimate reasons for off-balance-sheet accounting, it is often used to make a company look like it has far less debt than it actually does. Some types of off-balance-sheet accounting move debt to a newly created company specifically for that purpose, which was the case with Enron. These are called special purpose entities (SPEs) and are also known as variable interest entities (VIEs).
Off-balance-sheet entities can be created for several reasons, such as when a company needs to finance a business venture but doesn't want to take on the risk, or when there is too much debt to get a loan. By starting a new SPE, they can secure a loan through the new entity. There are situations where it makes sense to start an SPE. If your company wants to branch out into another area outside of its core business, an SPE will keep that risk from affecting the main balance sheet and profitability of the company. Prior to 2003, a company could own up to 97 percent of an SPE without having to report the liabilities of the SPE on its balance sheet.
Synthetic leases often use SPEs to hold title to a company's property and lease that property back to the company. Because of off-balance-sheet accounting, synthetic leases allowed companies to reap the tax benefits of ownership without having to list it as a liability on their balance sheets.
Synthetic leases could also be signed with some entity other than an SPE. Banks, for example, would often purchase property for businesses and lease it back to them via a synthetic lease. The company leasing the property avoids the liability on the balance sheet but still gets to deduct interest and depreciation from its tax bill.
The End of the Hiding Game
New requirements from the Financial Accounting Standards Board now require SPEs to be listed on a company's balance sheet. Section 401(a) of the Sarbanes-Oxley Act requires that annual and quarterly financial reports disclose all material off-balance sheet transactions, arrangements, and obligations. The rules also require most companies to provide an overview of known contractual obligations in an "easy-to-read tabular format"[ref].
This new ruling has essentially ended the days of the SPE and the synthetic lease -- even though they are still legitimate practices.