Q&A What Why

What are off-balance-sheet items and why are they important to some financial firms

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 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 review of balance sheet as a whole.

As discussed above, off balance sheet are not recorded in the balance sheet of the company and hence are very difficult to identify and track by the 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?

Off balance sheet are much useful for those companies that are highly leveraged. If the company is already having high debt-to-equity ratio, it will be a problem for a company to increase its debt. Also, it will be much expensive for the company to borrow more finances because of high interest rates charged by lender.

The measures of in debtness 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 off balance sheet activities.

Example of Off Balance Sheet

Some of the examples are provided and discussed as below-

One of the most common examples of off balance sheet is operating leases, which are not recorded in lessee’s balance sheet. The asset continues to appear in lessor’s books of accounts.
One more example is that when assets are secured and are sold off, the selling of the assets as investment 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.
All the above are the example of off balance sheet. 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 which forms part of asset and liabilities of the company but do not presented in the company’s balance sheet. Likewise, the presentation of off balance sheet activities, these items also shown in notes to accounts and are sometimes difficult to identify.Depending upon the business of the company, there can be large portion of off balance sheet 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 off balance sheet items is similar to those of off balance sheet activities.

Differentoff balance sheet items include

Operating Leases: It is an off balance sheet item in which rentals expenses are shown in lessee’s books of account and asset is shown in lessor’s books of account.
Cash in transit also forms part of notes to accounts but does not recorded in the balance sheetso, 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 company have the said asset category.
Other items are inventory write off and its disposal etc.

Off Balance Sheet Disclosures

According to 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 otherrelationships , 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 Sarbanes-Oxley Act 2002 in each quarterly and annual financial report of the company filed with 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 balance sheet of company and at the same time presented in the balance sheet whereas off balance sheet items are not recorded or presented in the balance sheet of company but forms part of balance sheet.
On balance sheet items are very easy to analyze as they appear clearly on the face of balance sheet whereas off balance sheet items are very difficult to analyze by the investors and proves to be matter of concern.
Example of on balance sheet items is Cash, Banks balance, fixed assets, etc.and example of off balance sheets items are operating leases, sold off investments, etc.

Benefits of Off balance Sheet Items

Benefits are provided and discussed as 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 company’s debt to equity ratio does not get affected with off balance sheet, it gives the advantage of financing without affecting 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, business does not involve in new debts and it does not affect relationship of 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 hands, presentation of large amount on loans on the face of balance sheet makes it less attractive and financially weaker to the investors.
With the help of Off Balance sheet, the liquidity of the business can be improved. Considering the example of operating lease, as 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 company. Also Company should use the off balance sheet for its better presentation of financial health to the investors.

How Does It Work?

Suppose ABC Manufacturers Ltd is undergoing an expansion plan and wants to purchase machinery to establish the second unit in another state. However, it does not have a financing arrangement as its balance sheet is already heavily financed. In such a case, it has two options. It can set up a joint ventureA joint venture is a commercial arrangement between two or more parties in which the parties pool their assets with the goal of performing a specific task, and each party has joint ownership of the entity and is accountable for the costs, losses, or profits that arise out of the venture.read more with other investors or companies to establish a new unit and obtain fresh financing in the new entity’s name. On the other hand, it can also chalk out the long-term lease agreement with the equipment manufacturer for the leasing of machinery, and in this case, it need not worry about obtaining new financing. Both of the above cases are examples of Off-balance sheet financing.

What is the Purpose of Off-Balance Sheet Items?

Key Features

List of Off-Balance Sheet Financing Items

The following are some of the common instruments for off-balance sheet items.

#1 – Leasing

It is the oldest form of off-balance-sheet financing. Leasing an asset allows the company to avoid showing financing of the assetAsset financing is defined as a loan taken out by an organization using balance sheet assets as collateral, such as land and buildings, vehicles, machinery, trade receivables, and short-term investments. The asset's value is divided into regular payment intervals of the asset's unpaid portion plus interest.read morefrom its liabilities, and lease or rent is directly shown as an expense in the Profit & Loss statement.

#2 – Special Purpose Vehicle (SPV)

Special purpose vehiclesA Special Purpose Vehicle (SPV) is a separate legal entity created by a company for a single, well-defined, and specific lawful purpose. It also serves as the main parent company's bankruptcy-remote and has its own assets and liabilities.read more or subsidiary companies are one of the routine ways of creating off-the-balance sheet financing exposures. It was used by Enron, which is known for one of the high-profile off-balance-sheet financing exposure controversies.

#3 – Hire Purchase Agreements

If a company cannot afford to purchase assets outright or obtain finance for the same, it can enter into a hire purchase agreement for a certain period with financiers. A financier will purchase the asset for the company, which will pay a fixed amount monthly until all the terms in the contract are fulfilled. The hirer can own the asset at the end of the hire purchase agreement.

#4 – Factoring

Under factoring, finance is obtained by selling account receivables to Banks. It is a type of credit service offered by Banks and other financial institutions to their existing clients. Banks offer immediate cash to the company after taking some cut from account receivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more for offering the service.

Significance For Investors

Under accounting standards for almost all major countries, it is mandatory to fully disclose all the off-balance sheet financing items for the company for that particular year. Investors should take note of these disclosures to understand the risks associated with such transactions fully.