Off-balance sheet exposures refer to activities that do not appear on the company’s balance sheet. Although not recorded on the balance sheet, they are still assets and liabilities of the company.
Off balance sheet items are in contrast to loans, debt and equity, which do appear on the balance sheet. Most commonly known examples of off-balance-sheet items include research and development partnerships, joint ventures, and operating leases. The above mentioned items do not appear on the company’s balance sheet until and unless they become actual assets or liabilities.
FEATURES OF OFF BALANCE SHEET EXPOSURES
- Off-balance sheet (OBS) items are an accounting practice whereby a company does not include a liability on its balance sheet.
- These items can be used to keep debt-to-equity (D/E) and leverage ratios low thus facilitating cheaper borrowing .
- These items can be used to share the risks and benefits of assets and liabilities with other companies, as in the case of joint venture (JV)
- Generally accepted accounting principles (GAAP) require an organization to disclose these Off balance sheet items in their notes to financial statements.
TYPES OF OFF BALANCE SHEET ITEMS
OPERATING LEASE : An operating lease is one of the most common examples of off-balance-sheet assets. The company owns the asset and has leased it to a lessee. So now the company only has to show the rental payments, or any other payments associated with the assets, on its financial statements.
ACCOUNTS RECEIVABLE : Accounts receivables can also be off-balance sheet items. Instead of listing this risky asset on its own balance sheet what most companies then choose to do is sell these assets to other companies, called a factor, and in turn, the factor acquires the risk associated with the asset.
LEASEBACK AGREEMENTS : Under a leaseback agreement, a company can sell an asset, such as a piece of property, to another entity. They may then lease that same property back from the new owner.
HOW OFF BALANCE SHEET FINANCING WORKS ?
Off balance sheet financing can be used to lessen the impact of ownership of certain assets and obligations of certain liabilities on the financial statements.
This is done by transferring the ownership of certain assets to other parties or by engaging in transactions that will allow them to not be reported in the financial statements under different accounting standards. But these items are still reported in the notes to financial statements.
Thus, in simple words off balance sheet exposures are an important concern for investors when assessing a company’s financial health & hence must be disclosed properly in the notes as per the rules laid down by GAAP.