This is the seventh article in a series of eight examining different forms of accounting manipulation. Previous articles included pieces on channel stuffing and improper revenue recognition.
Off-balance-sheet transactions refer to financial activities that do not appear on a company’s balance sheet but can have significant implications for its financial health and performance. Common examples would include joint ventures, special purpose entities, contingent liabilities and derivatives and hedging activities.
These transactions are typically used to manage risk, enhance financial flexibility, improve financial ratios, or achieve specific accounting objectives without directly affecting the reported assets and liabilities of a company.
While off-balance-sheet transactions serve a useful purpose, especially to mitigate risk, they also pose risks related to transparency and accountability. It is challenging to assess a company’s true financial position if significant amounts of debt or other obligations are buried in footnotes to the accounts and thus largely hidden from view.
In 2019, new accounting standards were introduced (ASC 842 for U.S. GAAP) that require companies to recognize most leases on their balance sheets, thereby reducing the prevalence of off-balance-sheet treatment for operating leases. However, financial innovation never stops and as one loophole closes there is always the risk that another will open.
As a consequence, companies that engage in significant off-balance sheet transactions will always be less transparent and thus pose greater risk of manipulation than companies that do not.
In this article, we offer a broad range of examples of companies that manipulated their accounts using off-balance-sheet transactions: Banco Espirito Santo, Parmalat, Satyam, Olympus, Lehman Brothers, and, of course, Enron, the great inventor.
Where possible, we complement these examples with readings from the Transparently Risk Engine, an AI-powered system that detects accounting manipulation. The TRE scores the quality of a company’s accounting on a 0-100% scale, in the process assigning them a rating of A+ to F. In some of the cases below, the TRE certainly picked up risky signals well before the problems bubbled to the surface.
Banco Espirito Santo (BES)
BES, a Portuguese bank, was involved in a major accounting scandal in 2014 that involved aggressive use of off-balance sheet transactions.
BES used a complex network of special purpose entities (SPEs) to hide billions of euros in debt from investors and regulators. These SPEs were often located in offshore tax havens and were not consolidated onto the bank's balance sheet. BES engaged in numerous related-party transactions with these SPEs, making it difficult to trace the flow of funds and assess the true extent of the bank's exposure. The bank's financial reporting lacked transparency, obscuring the risks associated with these off-balance-sheet activities.
BES's aggressive accounting practices and hidden debt eventually led to the bank's collapse in 2014. The Portuguese government had to intervene to rescue the bank, splitting it into a "good bank" and a "bad bank" to protect depositors. The scandal triggered criminal investigations, and several former executives were convicted of fraud and other financial crimes. The BES collapse had a significant impact on the Portuguese economy and shook investor confidence in the country's banking system.
The BES case highlights the dangers of using off-balance sheet entities and complex financial transactions to conceal debt and risk. It underscores the importance of transparency, robust accounting standards, and effective regulatory oversight in the banking sector.
Parmalat
Parmalat was an Italian dairy and food multinational. The company used off-balance-sheet entities in the early 2000s to conceal its true financial position and subsequently collapsed causing one of Europe's largest financial scandals.
Parmalat created a complex web of shell companies and subsidiaries, many of which were located in offshore tax havens. These entities were used to hide billions of euros in debt and losses from investors and regulators. The company engaged in complex financial transactions between these entities, often involving derivatives and other financial instruments, to further obscure its true financial position.
Parmalat failed to adequately disclose the nature and extent of its off-balance-sheet activities. The lack of transparency made it difficult for investors and analysts to understand the company's true financial health.
These fraudulent accounting practices eventually unraveled, leading to the company's collapse in 2003. It remains one of the largest corporate bankruptcies in European history. Several Parmalat executives, including the founder, were convicted of financial fraud and other crimes. The scandal shook investor confidence in Italian corporate governance and led to increased regulatory scrutiny of accounting practices, particularly related to off-balance-sheet transactions, in Europe.
In 2005, the relisted Parmalat scored 76% for accounting risk, according to the Transparently Risk Engine, putting it in the worst 1% of companies globally for accounting quality. The system flagged concerns with working capital, cash quality and asset quality that year.
Satyam
Satyam Computer Services, an Indian IT services company, was embroiled in a massive accounting scandal in the 2000s which featured aggressive use of off-balance-sheet transactions.
Satyam's founder and executives used a network of related-party transactions, often involving shell companies and fictitious entities, to siphon off funds from the company. These transactions were not properly disclosed or accounted for, making it difficult to trace the flow of money. By channeling funds through these off-balance-sheet entities, Satyam hid losses and inflated its reported profits. This created a false impression of financial health and misled investors about the company's true performance.
To further conceal its fraudulent activities, Satyam used a network of SPEs, allegedly controlled by the company's founder, to siphon off funds and hide the true nature of their financial transactions. The fraud involved the use of fictitious bank accounts and forged bank statements to inflate the company's cash holdings by billions of dollars. The company also created fictitious fixed assets and recorded fake sales to boost revenue and profits.
Thanks to poor corporate governance and lack of accounting transparency, the company's board of directors failed to detect or prevent the fraud. The fraud went undetected for several years.
When the fraud eventually unravelled in 2009, it caused one of the largest corporate accounting scandals in India's history. It shook investor confidence and led to calls for greater transparency and accountability in corporate governance. Satyam's founder and several other executives were arrested and convicted for their roles in the fraud. Satyam was eventually acquired by Tech Mahindra, another Indian IT services company, after a competitive bidding process.
The Satyam case underscores the critical importance of strong corporate governance, independent auditing, and transparent financial reporting. It serves as a stark reminder that off-balance-sheet transactions, while not inherently improper, can be easily abused to conceal fraudulent activities.
The risk reports generated by the Transparently Risk Engine for Satyam prior to 2003, the year in which manipulation supposedly began, suggested extreme manipulation risk. The risk engine awarded Satyam’s 2002 accounts a rating of “F” and a risk score that put the IT firm in the worst 2% of all listed companies globally for accounting quality. At the time, Satyam had a market capitalization of $1.7 billion. Risk scores of E or F are typically reserved for much smaller companies experiencing significant financial strain.
Olympus
Olympus Corporation, the Japanese optics and reprography product manufacturer, engaged in aggressive accounting practices related to off-balance-sheet transactions as part of a broader accounting fraud in the early 2010s.
Olympus used a complex web of transactions, known as "Tobashi" schemes in Japan, to hide investment losses dating back to the 1990s. These schemes involved transferring losses to off-balance-sheet entities and using inflated fees to obscure the true nature of the transactions. By keeping these losses off its balance sheet, Olympus created a false impression of profitability and financial health. This misled investors and allowed the company to continue operating for years while concealing its true financial condition.
When the scandal came to light in 2011, Olympus's share price plummeted by more than 80%, wiping out billions of dollars in market value. Several top executives, including the CEO, were arrested and convicted for their roles in the accounting fraud. Olympus faced significant fines from regulators and suffered severe reputational damage, shaking investor confidence in Japanese corporate governance.
The Transparently Risk Engine’s historical risk scores for Olympus averaged around 60% in the late 2000s and peaked at 70% in 2009, putting the company in the worst 7% of companies globally for accounting quality. The top concerns flagged by the system in Olympus’ 2009 accounts were smoothing activity, corporate governance and accruals management.
Lehman Brothers
The collapse of this global financial services firm was integral to the 2008 financial crisis.
Lehman Brothers engaged in complex transactions known as "Repo 105" transactions. These involved temporarily selling assets, such as mortgage-backed securities, shortly before the end of a reporting period. While technically structured as repurchase agreements (repos), these transactions were designed to move assets and their associated liabilities off Lehman's balance sheet temporarily, making leverage and financial health appear better than they were.
Lehman Brothers failed to adequately disclose the extent and nature of these Repo 105 transactions to investors and regulators, obscuring its true financial risk. When the sub-prime crisis hit in 2008, Lehman’s heavy reliance on Repo 105 transactions and other aggressive accounting practices contributed to a rapid downfall. The company filed for bankruptcy, the largest in U.S. history, sending shockwaves through the global financial system.
The Lehman Brothers collapse highlighted the dangers of complex and opaque off-balance-sheet transactions. These practices can create a dangerous illusion of financial stability, leading to disastrous consequences when economic conditions deteriorate.
China Huarong Asset Management
China Huarong Asset Management, a Chinese state-owned asset management company, suffered a significant share price decline in 2021 due to concerns about its accounting practices, particularly related to off-balance-sheet transactions.
Huarong was accused of using off-balance-sheet entities to hide billions of dollars in debt and risky investments. These entities were not fully consolidated onto the company's balance sheet, making it difficult for investors to assess the true extent of its financial risks. Huarong's financial reporting lacked transparency, and the company provided limited information about its off-balance-sheet activities. This opacity raised concerns about the company's risk management practices and the potential for hidden losses.
Huarong is an interesting case study because as a state-owned enterprise, it was perceived to have implicit government support, which might have led to moral hazard, encouraging the company to take on excessive risks.
Huarong's share price plummeted in 2021 as concerns about its accounting practices and financial health mounted. The company also faced credit rating downgrades, increasing its borrowing costs. The Chinese government ultimately intervened to restructure Huarong, injecting capital and replacing its management.
The Huarong case shook investor confidence in Chinese state-owned enterprises and highlighted the risks associated with opaque accounting practices and off-balance-sheet transactions.
Enron
The classic example of a company using fraudulent accounting with respect to off-balance-sheet transactions is Enron Corporation in the 1990s.
Enron created hundreds of SPEs, often with misleading names, to hide billions of dollars in debt, underperforming assets, and risky investments. It exploited accounting rules that allowed it to avoid consolidating the financials of these SPEs onto its balance sheet, as long as it could demonstrate that an independent third party had a significant financial stake in the SPE. This practice allowed Enron to present a much rosier financial picture than reality. It kept debt off the balance sheet, inflated earnings, and concealed the true risks associated with Enron’s operations.
When Enron's complex web of off-balance-sheet transactions began to unravel in 2001, it triggered a crisis of confidence among investors and creditors. The company quickly collapsed, leading to one of the largest bankruptcies in US history. The scandal exposed significant flaws in accounting regulations related to off-balance-sheet entities. It led to the passage of the Sarbanes-Oxley Act of 2002, which strengthened accounting rules and increased oversight of corporate financial reporting.
The Enron case serves as a stark reminder that aggressive use of off-balance-sheet transactions can have severe consequences. While these transactions can be legitimate for certain business purposes, they can also be easily abused to mislead investors and mask a company's true financial health.
From 1990-1997, when investment analysts consistently rated Enron as one of America’s best companies, the Off-balance-sheet transactions refer to financial activities that do not appear on a company’s balance sheet but can have significant implications for its financial health and performance. Common examples would include joint ventures, special purpose entities, contingent liabilities and derivatives and hedging activities. gave Enron risk scores between 93% and 95%, suggesting that it was among the absolute worst companies globally for risk of accounting fraud. The incidence of such a poor risk score for a large company was unprecedented.
%20-%20Wirecard.png)
