Question

1. While companies can create special purpose entities for sound business reasons, they can also make their financial statements look better by creating these entities and then not including them on their financial statements, primarily because:

   	A.	Assets are under-reported
   	B.	Assets are over-reported
   	C.	Debt is under-reported
   	D.	Expenses are under-reported

Answer 1

The correct answer is option C. Debts are under reported

A company can take out loans in the name of such entities and invest in more risky ventures without having a fear of having an adverse effect on the balance sheet and stake holders.

Sometimes such endeavours are high risk high reward opportunities and if something goes sideways then there are no immediate repurcation on the company.

Off-balance-sheet entitles are complex transactions where theory and reality collide. To understand how off-balance-sheet entities work, it is useful to have an understanding of corporate balance sheets. A balance sheet, also known as a "statement of financial position," reveals a company's assets, liabilities and owners' equity (net worth).

Investors use balance sheets to evaluate a company's financial health. In theory, the balance sheet provides an honest look at a firm's assets and liabilities, enabling investors to make a determination regarding the firm's health and compare the results against the firm's competitors. Because assets are better than liabilities, firms want to have more assets and fewer liabilities on their balance sheets.

Off-Balance-Sheet Entities: The Theory
Off-balance-sheet entities are assets or debts that do not appear on a company's balance sheet. For example, oil-drilling companies often establish off-balance-sheet subsidiaries as a way to finance oil exploration projects. In a clean and clear example, a parent company can set up a subsidiary company and spin it off by selling a controlling interest (or the entire company) to investors. Such a sale generates profits for the parent company from the sale, transfers the risk of the new business failing to the investors and lets the parent company remove the subsidiary from its balance sheet.

CORPORATE FINANCE & ACCOUNTING FINANCIAL STATEMENTS
Off-Balance-Sheet Entities: An Introduction
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By LISA SMITH
Updated Jun 25, 2019
Off-balance-sheet entitles are complex transactions where theory and reality collide. To understand how off-balance-sheet entities work, it is useful to have an understanding of corporate balance sheets. A balance sheet, also known as a "statement of financial position," reveals a company's assets, liabilities and owners' equity (net worth). (For a more detailed overview of balance sheets, see Reading The Balance Sheet and Breaking Down The Balance Sheet.)

TUTORIAL: Financial Concepts

Investors use balance sheets to evaluate a company's financial health. In theory, the balance sheet provides an honest look at a firm's assets and liabilities, enabling investors to make a determination regarding the firm's health and compare the results against the firm's competitors. Because assets are better than liabilities, firms want to have more assets and fewer liabilities on their balance sheets.

Off-Balance-Sheet Entities: The Theory
Off-balance-sheet entities are assets or debts that do not appear on a company's balance sheet. For example, oil-drilling companies often establish off-balance-sheet subsidiaries as a way to finance oil exploration projects. In a clean and clear example, a parent company can set up a subsidiary company and spin it off by selling a controlling interest (or the entire company) to investors. Such a sale generates profits for the parent company from the sale, transfers the risk of the new business failing to the investors and lets the parent company remove the subsidiary from its balance sheet.

Off-Balance-Sheet Entities: The Reality
Too often, however, off–balance-sheet entities are used to artificially inflate profits and make firms look more financially secure than they actually are. A complex and confusing array of investment vehicles, including but not limited to collateralized debt obligations, subprime-mortgage securities and credit default swaps are used to remove debts from corporate balance sheets. The parent company lists proceeds from the sale of these items as assets but does not list the financial obligations that come with them as liabilities.

For example, consider loans made by a bank. When issued, the loans are typically kept on the bank's books as an asset. If those loans are securitized and sold off as investments, however, the securitized debt (for which the bank is liable) is not kept on the bank's books. This accounting maneuver helps the issuing firm's stock price and artificially inflates profits, enabling CEOs to claim credit for a solid balance sheet and reap huge bonuses as a result. (Sneaky Subsidiary Tricks Can Cloud Financials provides insight into how the process works with subsidiaries, and it's not the only trick companies use.)