What Is Off-Balance Sheet (OBS)?
Off-balance sheet (OBS) items are assets or liabilities that do not appear on a company's balance sheet.Although not recorded on the balance sheet, they are still assets and liabilities of the company.
Key Takeaways
- Off-balance sheet (OBS) items are an accounting practice whereby a company does not include a liability on its balance sheet.
- While not recorded on the balance sheet itself, these items are nevertheless assets and liabilities of the company.
- Off-balance sheet items can be used to keep debt-to-equity (D/E) andleverage ratioslow, facilitating cheaper borrowing and preventing bond covenants from being breached.
- The practice of off-balance sheet financing has come under increasing scrutiny after a number of accounting scandals revealed the misuse of the practice.
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Understanding Off-Balance Sheet (OBS)
Off-balance sheet items are an important concern for investors when assessing a company's financial health. Off-balance sheet items are often difficult to identify and track within a company's financial statements because they often only appear in the accompanying notes.Also, of concern is some off-balance sheet items have the potential to become hidden liabilities. For example, collateralized debt obligations (CDO) can become toxic assets, assets that can suddenly become almost completely illiquid, before investors are aware of the company's financial exposure.
Off-balance sheet items are typically those not owned by or are a direct obligation of the company. For example, when loans are securitized and sold off as investments, the secured debt is often kept off the bank's books. Prior to a change in accounting rules that brought obligations relating to most significant operating leases onto the balance sheet, an operating lease was one of the most common off-balance items.
Off-balance sheet items are not inherently intended to be deceptive or misleading, although they can be misused by bad actors to be deceptive. Certain businesses routinely keep substantial off-balance sheet items. For example, investment management firms are required to keep clients' investments and assets off-balance sheet. For most companies, off-balance sheet items exist in relation to financing, enabling the company to maintain compliance with existing financial covenants. Off-balance sheet items are also used to share the risks and benefits of assets and liabilities with other companies, as in the case of joint venture (JV) projects.
Types of Off-Balance Sheet Items
There are several ways to structure off-balance sheet items. The following is a short list of some of the most common:
Operating Lease
An OBSoperating leaseis one in which the lessor retains the leased asset on its balance sheet. The company leasing the asset only accounts for the monthly rental payments and other fees associated with the rental rather than listing the asset and corresponding liability on its own balance sheet. At the end of the lease term, the lessee generally has the opportunity to purchase the asset at a drastically reduced price.
Leaseback Agreements
Under aleaseback agreement, a company can sell an asset, such as a piece of property, to another entity.They maythen lease that same property back from the new owner.
Like an operating lease, the company only lists the rental expenses on its balance sheet, while the asset itself is listed on the balance sheet of the owning business.
Accounts Receivables
Accounts receivablerepresentsa considerable liability for many companies. This asset category is reserved for funds that have not yet been received from customers, so the possibility of default is high. Instead of listing this risk-laden asset on its own balance sheet, companies can essentially sell this asset to another company, called afactor, which then acquires the risk associated with the asset. The factor pays the company a percentage of the total value of all ARupfront and takes care of collection. Once customers have paid up, the factor pays the company the balance due minus a fee for services rendered. In this way, a business can collect what is owed while outsourcing the risk of default.
How Off-Balance Sheet Financing Works
An operating lease, used in off-balance sheet financing (OBSF), is a good example of a common off-balance sheet item. Assume that a company has an established line of credit with a bank whose financial covenant condition stipulates that the company must maintain its debt-to-assets ratio below a specified level. Taking on additional debt to finance the purchase of new computer hardware would violate the line of credit covenant by raising the debt-to-assets ratio above the maximum specified level.
OBSF is controversial and has attracted closer regulatory scrutiny since it was exposed as a key strategy of the ill-fated energy giant Enron.
The company solves its financing problem by using a subsidiary or special purpose entity (SPE), which purchases the hardware and then leases it to the company through an operating lease while legal ownership is retained by the separate entity. The company must only record the lease expense on its financial statements. Even though it effectively controls the purchased equipment, the company does not have to recognize additional debt nor list the equipment as an asset on its balance sheet.
Off-Balance Sheet Financing Reporting Requirements
Companies must followSecurities and Exchange Commission(SEC) andgenerally accepted accounting principles(GAAP) requirements by disclosing OBSF in the notes of theirfinancial statements. Investors can study these notes and use them to decipher the depth of potential financial issues, although as the Enron case showed, this is not always as straightforward as it seems.
In Feb. 2016, theFinancial Accounting Standards Board(FASB), the issuer of generally accepted accounting principles, changed the rules for lease accounting. It took action after establishing thatpublic companiesin the United States withoperating leasescarried over $1 trillion in OBSF for leasing obligations. According to its findings, about 85% of leases were not reported on balance sheets, making it difficult for investors to determine companies' leasing activities and ability to repay their debts.
This OBSF practice was targeted in 2019 when Accounting Standards Update 2016-02 ASU 842 came into effect. Right-of-use assets and liabilities resulting from leases are now to be recorded on balance sheets. According to the FASB: “A lessee is required to recognize assets and liabilities for leases with lease terms of more than 12 months.”
Enhanced disclosures inqualitativeandquantitativereporting in footnotes of financial statements is also now required. Additionally, OBSF for sale andleasebacktransactions will not be available.
Example of Off-Balance Sheet Activity
TheEnronscandal was one of the first developments to bring the use of off-balance-sheet entities to the public's attention. In Enron's case, the company would build an asset such as a power plant and immediately claim the projected profit on its books even though it hadn't made one dime from it. If therevenue from the power plant was less than the projected amount, instead of taking the loss, the company would then transfer these assets to an off-the-books corporation, where the loss would go unreported.
Enron, once considered one of the most innovative and successful energy companies in the United States, collapsed in 2001 amidst revelations of widespread accounting fraud and corruption. The company had engaged in complex financial transactions and partnerships, many of which were not properly disclosed in its financial statements. These off-balance sheet entities were used to hide debt and losses, giving the appearance of financial health and profitability when, in reality, Enron was facing significant financial troubles.
One of the most notorious off-balance sheet entities created by Enron was the special purpose entity discussed earlier in this article. Enron used SPEs to keep debt off its balance sheet, thus presenting a much healthier financial picture to investors and analysts. The company transferred assets and liabilities to these entities, often through complicated financial maneuvers, allowing Enron to artificially inflate its reported earnings and hide its true financial condition.
Which Accounts Do Not Appear on the Balance Sheet?
Certain financial transactions do not appear on the balance sheet if they qualify as 'off-balance sheet transactions'. These activities are intentionally left off of financial statements, though they may cause a company's financial position to be misstated. These occur based on the circ*mstances of the transaction (i.e. a company may not actually own something, therefore it does not meet GAAP reporting requirements).
Is Off-Balance Sheet Financing Legal?
It is legal, but the information still must be included in the notes of financial statements, per the SEC and GAAP requirements.
What Is an Example of an Off-Balance Sheet Item?
Leases are among the most common examples. A company leasing an asset lists rent payments and other applicable fees, but it does not list the asset and any corresponding liabilities. Some cases might involve a leaseback agreement in which a company leases an asset after selling that asset to its new owner.
How Do You Recognize Off-Balance Sheet Items?
It's important to read any company's balance sheets closely, including all notes. When seeing common OBS items such as leased items or partnerships with factors that handle accounts receivables, it's a good idea to look especially closely.
The Bottom Line
Assets or liabilities not included on a company's balance sheet are known as off-balance sheet items. Reasons they'll be excluded from a balance sheet include a lack of direct ownership or direct obligation. While the practice is legal, companies still must address these OBS items in notes on their balance sheets.
