What is the Off-Balance Sheet?

Components of Off-Balance Sheet

We know that the basic balance sheet consists of three segments: assets, liabilities, and Owner equity or Equity capital plus reserves. Off-balance consists of two components as Assets and liabilities. Some items are associated with the business and do not appear directly on 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), operating lease (assets), etc. In some cases, any banks/ financial institutions offer an array of financial activities such as brokerage services and 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 clients, 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 cannot 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 per the machine owner’s quotation. Thus the leverage position is not compromised. However, the shareholders should also be informed about the company’s current scenario, such as the additional revenue not coming from the company’s fixed assets. In case of any damage caused to the machinery, the entire liability would be borne by the Company. Thus, the additional risk should be ascertained as the company’s liability in case of any damages.

Example #2

ABC Bank Ltd offers its clients a savings account and other banking transactions. A high Net worth individualHigh Net Worth IndividualA high net worth individual possesses liquid assets worth $1 million to $5 million. They are also referred to as HNWIs. In order to qualify for HNWI status, the individual’s liquid assets must be readily available in their bank or brokerage accounts. The assets must be accessible and easily converted into cash.read more may ask for a service 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 would provide the service via that particular brokerage firm. Thus the assets would directly come under the brokerage firm, but the bank itself would control them. The AUM would not be recorded within the bank.

Advantages of Off-Balance Sheet

  • Off-balance sheet financingOff-balance Sheet FinancingOff-balance sheet financing is a company’s practice of excluding certain liabilities and, in some cases, assets from getting reported in the balance sheet in order to keep the ratios such as the debt-equity ratios low to ease financing at a lower rate of interest and also to avoid the violation of covenants between the lender and the borrower.read more does not affect the liquidity position of a company adversely.Capital expenditures related to the assets used are recorded in the lender’s books.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 depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year.
  • read more 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 the 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 with a higher debt-to-equity ratio would tend to benefit 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 company’s liquidity position, whereas any damages or accidental incidents might lead to an increase in maintenance costs.The management should clear machinery usage before 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 much more compared to what it has shown to the shareholders, creditors, and other third parties associated with it.

Limitations

  • Off-Balance sheets and OBS financing are allowed under the GAAPGAAPGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting.read more, whereas the company has to maintain certain rules prescribed by GAAP.Due to the present uncertainty surrounding 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, starting from 1st January 2019 onwards. As per the rule, the companies which used to show the operating leases under footnote have to show the expenses such as office leases, rent for equipment, and 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, and banks will likely 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 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 effectively so that the leverage position can be evaluated properly.

This article has been a guide to what is Off-Balance Sheet and its definition? Here we discuss examples of Off-Balance Sheet (OBS) and its advantages and disadvantages. You can learn more about accounting from the following articles –

  • Balance Sheet ReconciliationComparative Balance SheetAnalysis of a Balance SheetList of Balance Sheet Ratios