What is the 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 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. Some items are associated with the business and do not appear directly in the balance sheetThe Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more; they are invisible. E.g., leverage in the form of debt (liability items), or operating lease (assets), etc. In some cases, any banks/ financial institutions, offer an array of financial activities such as brokerage services, asset managementAsset ManagementAsset management is a method of managing funds and investing in both traditional and specialized products in order to generate returns consistent with the investor's risk tolerance. read more to their esteemed client, which might not be their original business.
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Off-Balance Sheet Examples
Example #1
XYZ Ltd. has a D/E ratioD/E RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. read more 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 an operating lease optionLease OptionA Lease Option is an agreement between the lessor & the lessee where the latter can buy the property (commercial/residential) after paying up at the end of the lease term or after a particular period. read more, where the company would only pay 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 damage 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.
Example #2
ABC Bank ltd offers a 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 requires 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 bank itself would do the controlling. 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 in the books of the lender.
- Lower fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more would result in lower depreciation and hence lower operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more.
- 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 expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more is required for new fixed assets.
Disadvantages
- 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 management should clear the usage of machinery before the particularly fixed assets are used. Some other companies bear the ownership of the fixed asset, and they decide the extent of its usage.
- 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
- Off-Balance sheet and OBS financing are allowed under the GAAPGAAPGenerally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors.read more, 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. It might lead to certain ambiguity among the shareholders and third parties.
Changes in the Off-Balance Sheet
As per the new corporate accounting ruleCorporate Accounting RuleAccounting rules are guidelines to follow for registering daily transactions in the entity book through the double-entry system. Here, every transaction must have at least 2 accounts (same amount), with one being debited & the other being credited. read more, the companies have to show operating leases on their balance sheet, which has started from the 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 leasesOperating LeasesAn operating lease is a type of lease that allows one party (the lessee), to use an asset held by another party (the lessor) in exchange for rental payments that are less than the asset's economic rights for a particular period and without transferring any ownership rights at the end of the lease term.read more 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 fundsQuantitative FundsQuant funds, also known as quantitative funds, are types of investment funds in which investment selection and associated decisions are made using analytical methods and advanced quantitative analysis rather than human intellect and judgement.read more, banks will likely to change their mode of evaluating the financial position of a company that has high operating lease assets.
Conclusion
Earlier, the companies with hidden assets and liabilities tend to show a different picture to the investors, potential investors, and third parties. Thus the actual picture was not visible. After the introduction of the 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 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.
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