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Off Balance Sheet Financing

When a company takes out a loan from a bank or a line of credit from a vendor, it records a liability for the loan and records the cash received from the financing. These traditional sources of financing are always reported on the balance sheet as either a short-term or long-term liability. This makes sense when you think about it. The company owes the bank or the vendor money, so it should report that liability on the balance sheet.

If liabilities are always reported on the balance sheet, what is off balance sheet financing? Off balance sheet financing happens when a company purchases an asset with a loan and doesn't report the loan on its balance sheet. I know this sounds contradictory from what I just said, but there are exceptions to the rules.

A capital lease is one of those exceptions. Normally when a company leases an asset like a car or a piece of machinery, it simply records the lease payments as an expense. It never records the asset on the books because it doesn't actually own the asset. These leases are called operating leases. Capital leases are slightly different. If a lease meets one of four requirements, it is considered a capital lease and the company has to capitalize the asset it is leasing. In other words, the company has to report the leased asset on its balance sheet as if it owned the asset. The tricky part is that the company doesn't report a liability because it doesn't owe any money on for the asset. The car or equipment is leased. There is no loan.

Thus, an asset is recorded on the books without a corresponding liability. The liability is only reported in the footnotes of the financial statements. That's where the name off balance sheet comes from.

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