Off-Balance SheetAssets or liabilities that don't appear on the balance sheet
When a business acquires an asset, it records the acquisition in its books.
Then, the asset should appear on its balance sheet.
The same goes for when the business accrues a liability (e.g. taking out a loan).
The business will record whatever the amount of the liability is.
At the end of the period, whatever the balance of the liability is, it should appear on the business’s balance sheet.
After all, a balance sheet is supposed to show the balance of the assets that the business owns, as well as the liabilities that it owes.
However, a business may sometimes own assets or owe liabilities that don’t necessarily appear on its balance sheet.
It could either be assets that the business doesn’t own, however, it still receives the benefits that such assets provide.
Or it could be financial obligations that the business doesn’t directly owe.
We refer to these assets or liabilities as off-balance sheet items.
Now, while they don’t appear on the business’s balance sheet, they still appear on its financial statements, particularly its notes to financial statements.
In this article, we will be discussing what “off-balance sheet” is.
How does an off-balance sheet item affect the financial condition of a business? Is it legal or ethical to not record assets or liabilities on the balance sheet? How does off-balance sheet financing work?
We’ll try to answer these questions as we go along with the article.
What is Off-Balance Sheet (OBS)?
Off-balance sheet (OBS) refers to items (usually assets and/or liabilities) that effectively belong to the business but don’t appear on its balance sheet.
In contrast, assets and/or liabilities that do appear on the balance sheet are referred to as on-balance sheet items. There are various reasons why a business would have off-balance sheet items. It could be that these items don’t have equity or debt linked to them.
It could also be that the business doesn’t have a direct claim to these items. Rather, an external source has a direct claim on them. However, the business still enjoys the benefits that such items provide.
Whatever the reason, these items don’t appear on the business’s balance sheet.
A prominent example of an off-balance sheet item is an operating lease. Well, at least it was. Before the recent changes in lease accounting, an operating lease won’t appear on any business’s balance sheet.
The lessee only records the lease and other expenses associated with the operating lease. However, with the recent changes in lease accounting, businesses need to report operating leases on their respective balance sheets.
The Purpose of Off-Balance Sheet Items
Off-balance sheet financing in itself isn’t deceptive or manipulative. Some circumstances may even necessitate it. For example, a business may offer asset management or brokerage services to its clients. Now while it is the business that manages that asset, its ownership still belongs to the client. Thus, the business has no direct claim over the asset, making it an off-balance sheet asset. The business has to include information regarding the off-balance sheet asset in its notes for financial statements. Alternatively, that business may formally report such an asset as “assets under management”.
Another benefit of off-balance sheet financing is that it does not negatively affect the financial position of the business, which ultimately results in a cleaner presentation of the balance sheet. For example, loans generally negatively affect the financial position of a business. However, off-balance sheet loans don’t.
The Issue With Off-Balance Sheet Items
An issue that may arise with off-balance sheet items is that they can be difficult to identify and track within a business’s financial statement. Do remember that they don’t appear on the balance sheet (hence, off-balance sheet).
They only appear on the business’s notes to financial statements. This isn’t inherently a bad thing.
However, the information regarding off-balance sheet items may be deeply buried among the pile of information included in the notes. Even worse is if the business is intentionally trying the hide the information which can be a sign of deception.
Another concern would be the potential of some off-balance sheet items to become hidden liabilities.
For example, some off-balance sheet assets can become toxic assets – previously liquid assets that become almost entirely illiquid. Since they don’t appear on the balance sheet, investors might not immediately become aware of the presence of such off-balance sheet assets.
Intentional misuse of off-balance sheet financing can mislead investors into thinking that the business is in a better financial position than it actually is. A real-world example of such an occurrence is the Enron scandal.
With the deceptive and manipulative use of off-balance sheet items, the management of Enron was able to trick its investors into thinking that the business is doing well.
In reality, the business was incurring losses after losses but was able to hide with deceptive off-balance sheet financing.
Due to the possibility of misusing off-balance sheet items, many laws and regulations were implemented to ensure that the practice of off-balance sheet financing is used correctly. The recent change in lease accounting is one of such laws and regulations. With it, businesses now have to record operating leases on their balance sheet.
Off-Balance Sheet Financing Reporting Requirements
Businesses in the US have to follow Securities and Exchange Commission (SEC) and Generally Accepted Accounting Principles (GAAP) requirements regarding off-balance sheet financing reporting.
A business has to disclose any off-balance sheet items in its notes to financial statements. This allows investors and other external parties to study them and assess their effects on the financial position of the business.
The problem with this is that there is no strict guideline yet on how to present the information regarding off-balance sheet items in the notes to financial statements. It’s not as straightforward as one would hope.
Still, the proper authorities are making progress in the reporting of off-balance sheet items.
The recent change in lease accounting proves this. With it, a previously off-balance sheet item is now an on-balance sheet item: operating leases. This makes it easier to identify and assess the leasing activities of a business.
Example of Off-balance Sheet Items
Here are some examples of off-balance sheet items:
Total Return Swap
A total return swap is a type of derivative contract between the two parties that can be an off-balance sheet item.
Under such a contract, one party makes payments based on a set rate agreed upon by both parties, while the other party makes payments based on the total return of the underlying asset (which could be a bond, equity interest, or loan).
The party receiving the total returns earns income from the underlying asset without actually owning it.
Accounts receivable are amounts that customers owe to the business.
Ideally, the business would want to collect them all, but the reality isn’t like that.
There’s always the risk of customers defaulting on their accounts.
Rather than deal with such risk, the business may opt to undergo accounts receivable factoring. The business essentially sells its accounts receivable to a factor.
The payment would only be a percentage of the total value of the accounts receivable though.
The factored accounts receivable become off-balance sheet items.
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University of New Orleans "The off-balance sheet banking risk of large U.S. commercial banks " White paper. September 21, 2022
MIT Sloan "The Case for an Off-Balance-Sheet Controller" Page 1 . September 21, 2022