Introduction of Off Balance Sheet
Off Balance sheet refers to those activities of assets or debt or financing liabilities of the company that belongs to the company’s balance sheet but do not appear/present in the balance sheet i.e. the activities that are not recorded in the balance sheet but the company has the rights and obligations for those activities and has the impact on its financial health that taken into consideration by many investors during the review of a balance sheet as a whole.
As discussed above, off balance sheets are not recorded in the balance sheet of the company and hence are very difficult to identify and track investors. Many times, they are mentioned in the accompanying notes. They also form part of hidden liabilities which makes it a matter of concern.
How Does it Work?
It is much more useful for those companies that are highly leveraged. If the company is already having a high debt-to-equity ratio, it will be a problem for the company to increase its debt. Also, it will be much more expensive for the company to borrow more finances because of the high-interest rates charged by lenders.
The measures of debts of the company such as debt to equity (D/E) and other leveraged ratios do not get affected due to off balance sheet activities. This helps the company in its borrowing. The liquidity position of the company is also not affected due to its activities.
Example of Off Balance Sheet
Some of the examples are provided and discussed below-
- One of the most common examples is operating leases, which are not recorded in the lessee’s balance sheet. The asset continues to appear in the lessor’s books of accounts.
- One more example is that when assets are secured and are sold off, the selling of the assets as investments does not appear in the books of accounts.
- Any disposal of inventory does not appear in the balance sheet but forms part of notes to accounts.
- Various joint ventures, Research, and development activities also form part of examples of off balance sheet activities
Off Balance Sheet Items
Similar to above, off balance sheet items are those items that form part of the assets and liabilities of the company but do not present in the company’s balance sheet. Likewise, the presentation of its activities, these items are also shown in notes to accounts and are sometimes difficult to identify. Depending upon the business of the company, there can be a large portion of these items in many books of accounts of the company. These items can be formally shown as “assets under management” as a presentation. The working of these items is similar to those of off balance sheet activities.
Different off balance sheet items include
- Operating Leases: In this, rentals expenses are shown in the lessee’s books of account and asset is shown in the lessor’s books of account.
- Cash in transit also forms part of notes to accounts but does not record in the balance sheets, it is off balance sheet item
- Accounts Receivable: It may also be the off balance sheet item and default risk under this category is highest. Almost all of the companies have the said asset category.
- Other items are inventory write-off and their disposal etc.
Off Balance Sheet Disclosures
- According to the Securities and Exchange Commission and generally accepted accounting principles (GAAP), every public company is required to disclose all its off balance sheet activities in the notes of its financial statements, the transactions, obligations (including contingent obligations), arrangements or any other relationships, with unconsolidated entities that have or may have in future any material effect on company’s financial conditions, revenues, Changes in financial conditions, expenses, results of operations, liquidity, capital expenditures or capital resources.
- The Securities and Exchange Commission (SEC) has recently proposed the rules to implement the above disclosure as per sec 401(a) of the Sarbanes-Oxley Act 2002 in each quarterly and annual financial report of the company filed with the SEC.
- The above-proposed disclosures are also required by Foreign Companies and Canadian companies in their annual returns.
On Balance Sheet vs Off Balance Sheet
- On Balance sheet items are those that form part of the balance sheet of the company and are at the same time presented in the balance sheet whereas off balance sheet items are not recorded or presented in the balance sheet of the company but form part of the balance sheet.
- On balance sheet items are very easy to analyze as they appear clearly on the face of the balance sheet whereas off balance sheet items are very difficult to analyze by the investors and prove to be a matter of concern.
- Example of on balance sheet items is Cash, Banks balance, fixed assets, etc. and example of off balance sheet items are operating leases, sold-off investments, etc.
Benefits of Off Balance Sheet Items
Benefits are provided and discussed below-
- The Off balance sheet does not affect the liquidity position of the company.
- As the items are not included in the balance sheet, the company is not liable to pay them on a priority basis. As these do not form part of liability, it poses little risk to the company.
- As the company’s debt-to-equity ratio does not get affected by off balance sheets, it gives the advantage of financing without affecting the debt burden.
- In normal debts, the management needs to go through the conversations and approvals of directors to get new debts. Due to off balance sheet, the business does not involve in new debts and it does not affect the relationship of the business with suppliers, lenders, or directors.
- The ratios and reported numbers of the business do not get affected due to off balance sheet. On the other hand, the presentation of large amounts on loans on the face of the balance sheet makes it less attractive and financially weaker to investors.
- With the help of Off Balance sheet, the liquidity of the business can be improved. Considering the example of an operating lease, only rental payment needs to be paid instead of paying full investment, in which case, funds can be used elsewhere.
Conclusion
Off Balance sheet can be proved to be much beneficial for the company considering its advantages. If the company wants to acquire more debts, it can go for the off balance sheet, as it does not affect the ratios of the company. Also, Company should use the off balance sheet for its better presentation of financial health to the investors.
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This is a guide to Off Balance Sheet. Here we also discuss the introduction and how does it work? along with benefits and examples of off balance sheets. You may also have a look at the following articles to learn more –
