Diversification and the Accounting for New Projects on or Off the Balance Sheet

Abstract

A debt financing transaction that is structured to avoid explicit liability recognition is known as off-balance sheet financing (OBSF). Purported benefits from OBSF include raising cheaper debt by guaranteeing debt repayments unencumbered by current debt contracts, maintaining desired debt-to-capitalization ratios, preserving credit ratings and future borrowing capacity, funding projects beyond approved capital budgets. Despite its appeal, many firms choose conventional financing (balance sheet financing or BSF). We demonstrate that allowing firms the choice between OBSF and BSF can play a positive informational role, notwithstanding the argument that permitting this choice compromises the representational faithfulness of the balance sheet. In the context of raising funds for a new project, we derive an equilibrium in which the firms divide themselves between OBSF and BSF in a manner that provides useful information for valuing the firms' stock prices. Consistent with anecdotal evidence we demonstrate riskier firms use OBSF and the projects financed are the riskier projects.