What is Off Balance Sheet?
Off-balance sheet items are those assets that are not directly owned by the business and therefore do not appear in the basic format of the balance sheet, although they tend to impact indirectly to the financials of the company. Operating lease is a glaring example of ‘off-balance sheet’ item, where the asset value is not recorded in the balance sheet, but in case of any misuse, the entire amount of the asset would be borne by the company.
Components of Off-Balance Sheet
We know that the basic balance sheet consists of three segments, viz. Assets, liabilities, and Owner equity or Equity capital plus reserves. For off-balance consists of two components such as Assets and liabilities. There are items that are associated with the business and do not appear directly in the balance sheet, they are invisible in nature. For example, leverage in the form of debt (liability items), or operating lease (assets), etc. In some cases, for any banks/ financial institutions, they offer an array of financial activities such as brokerage services, asset management to their esteemed client, which might not be their original business.
Off-Balance Sheet – Example #1
XYZ Ltd. has a D/E ratio of 3.5. Because of high leverage, the company is not being able to do a capital expenditure worth $5 million, which would increase D/E to 4.5. Thus, it might hinder shareholders confidence. So the management of the company might opt for operating lease option, where the company would only pay a Machinery rent as per the quotation of the machine owner. Thus the leverage position is not compromised. However, the shareholders should also be informed about the current scenario of the company such as the additional revenue is not coming from the fixed assets of the company. In case of any damaged caused in the machinery, the entire liability would be borne by the Company. Thus, the additional risk should be ascertained as the liability of the company in case of any damages.
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Off-Balance Sheet – Example #2
ABC Bank ltd offers savings account and other banking transactions to their clients. A high Net worth individual may ask for a service that is not offered by the bank itself. However, they can’t refuse as the above client has a long relationship with the bank. Suppose, the client has a requirement for brokerage services. The bank has contacts with brokerage firms and it would provide the service via that particular brokerage firm. Thus the assets would directly come under the brokerage firm, but the controlling would be done by the bank itself. The AUM would not be recorded within the bank.
Advantages of Off-Balance Sheet
- Off-balance sheet financing does not affect the liquidity position of a company adversely.
- Capital expenditures related to the assets used are recorded to the books of the lender.
- Lower fixed assets would result in lower depreciation and hence lower operating expenses.
- Whenever the assets are required, the expense is shown as a rental expense and within under Income statement.
- Purchase and installation of any fixed asset would aid an increase in liability like long term borrowings or a decrease in reserves. Thus, it retains the liquidity positions of the company.
- The companies which already have a higher debt to equity ratio would tend to be benefitted from off-balance-sheet financing, as no further capital expenditure is required for new fixed assets.
Disadvantages of OBS
- Using rented machinery retains the liquidity position of the company, whereas any damages or accidental incidents might lead to an increase in maintenance costs.
- The usage of machinery should be cleared by the management before the particularly fixed assets are used. The ownership of the fixed asset is borne by some other companies and the extent of its usage is being decided by the owner of the fixed assets.
- The actual liability of the company is actually much more compared to what it has shown to the shareholders, creditors and other third parties associated with the company.
Limitations of OBS
- Off-Balance sheet and OBS financing are allowed under the GAAP, whereas the company has to maintain certain specific rules as prescribed by GAAP.
- Due to the present uncertainty surrounded by the credit markets, the rentals could be sky high and off-balance sheet financing can lead to higher costs.
- The current picture of the company is not visible unless the off-balance sheet items are taken into account in a detailed manner. This might lead to certain ambiguity among the shareholders and third parties.
Changes in the Off-Balance Sheet
As per the new corporate accounting rule, the companies have to show operating leases on their balance sheet which has started from effective date of 1st January 2019 onwards. As per the rule, the companies which use to show the operating leases under footnote has to show the expenses such as office leases, rent for equipment, cars to the Liability side. It will affect the company’s leverage position. Thus companies having higher operating lease like renting airplanes, ships, etc would get affected badly as the Liability associated with them would tend to increase. Thus, the investors, financial analysts, quantitative funds, banks will likely to change their mode of evaluating the financial position of a company that has high operating lease assets.
Earlier, the companies with hidden assets and liabilities tend to show a different picture to the investors, potential investors and to the third parties. Thus the actual picture was not visible. After the introduction of disclosure of hidden assets and liabilities into within the Balance sheet, the related party along with the investors would tend to notice the real picture of the company. The rule emphasizes on the theory that, the operating assets which earn revenue for the company should be disclosed properly and in an effective manner so that the leverage position could be evaluated properly.
This has been a guide to what is Off-Balance Sheet and its definition? Here we discuss examples of Off-Balance Sheet (OBS) along with its advantages and disadvantages. You can learn more about accounting from the following articles –