Assets or liabilities that do not appear on a company's balance sheet are referred to as Off-Balance Sheet (OBS) items. They are typically assets that are not directly owned or liabilities not directly obliged by the company. These items are normally owned or claimed by an external source. Although OBS items are not recorded on the balance sheet and are not directly linked to the company, these items are still considered as the company's assets and liabilities.
Companies may try to present a cleaner balance sheet to their investors by keeping certain assets and liabilities off their balance sheets. They often do so by engaging in activities that were designed to shift the legal ownership of certain assets or liabilities to an external entity. Hence, tracking OBS items is a must to fully understand a company's financial standing.
Inherently, OBS financing is not designed to be deceptive or misleading although some companies may misuse it. Companies like investment firms are required to keep their clients' investments and assets off their balance sheets. OBS financing also exists so that companies can maintain compliance with existing financial regulations.
Common Types of Off-Balance Sheet (OBS) Items
There are several types of OBS items. The following is a list of the common types of OBS items used by companies:
Operating Lease
An operating lease is a contract whereby an external entity leases an asset to a company that gives the company the right to use and operate the asset without direct ownership. The company does not own the asset or any liability related to it and hence, only has to record the monthly rental payments and other fees related to the lease as expenses. Usually, the company has the opportunity to purchase the asset from the lessor at a reduced price at the end of the lease term.
Accounts Receivable (AR)
An account receivable is a company's asset. It is the funds that the company has yet to receive from its customers and carries possible default risks. Instead of bearing the risks, some companies may sell this asset to another entity. The entity will then pay a percentage of the total AR value upfront to the company and takes care of the collection together with the default risks. The entity will pay the company the balance once the customer has cleared their payment and collect some service fees for services rendered. As such, the company no longer holds the assets and hence, does not have to record them in its balance sheets.
How it works?
To understand how OBS may work for most companies in real life, a good example is using the operating lease. If a company has a financial agreement with a bank that states that the company's debt-to-assets ratio must be maintained below a specific level. When a company wishes to purchase a new asset by borrowing money from the bank, this would raise the company's debt-to-assets ratio above the specific level that may violate the agreement. The company may resolve this issue by using a subsidiary or special purpose entity to purchase the new asset and then uses an operating lease to lease it to the company. As such, the legal ownership of the asset together with the liability obligation will be retained by the entity. The company will only record the lease as expenses in their account.
Reporting Requirements on Off-Balance Sheet Financing
OBS financing is available for use at a company's discretion and is allowable under accounting standards with some rules governing over it. Although OBS items may not appear in the balance sheets, companies are required to disclose them in the footnotes of financial statements. Besides, in recent years, there are lesser and lesser off-balance-sheet transactions allowed in accounting standards. For example, in 2019, the Financial Accounting Standards Board (FASB) has updated its accounting standard to include the assets and liabilities that arise from right-of-use leases on a company's balance sheet.
The Bottom Line
Although there are rules governing the use of OBS financing, one has to read a company's full financial statement and look for keywords related to OBS transactions such as lease expenses, rental, or partnerships to fully understand the company's financial standing.
The appropriateness of these OBS transactions needs to be analyzed critically as well. If in doubt on the extent to which the OBS transaction may affect the company's true liabilities, one should always contact the company's respective department to clarify. The key to making an informed and sound decisions is by understanding the company's current and future financial position.
Recording Off-balance sheet Transaction in TreezSoft
With TreezSoft Cloud Accounting, recording your OBS transaction is done automatically by our system. TreezSoft will automatically help you raise the respective double entries. You can conveniently retrieve your reports in just a few clicks as well.
You can read more on Transfer funds in TreezSoft by visiting these links:
TreezSoft is a cloud accounting software for Small and Medium-sized Enterprises (SMEs). It allows you to access your financial information anytime, anywhere. It also allows you to have unlimited users for FREE for your account in TreezSoft. Our aim is to help reduce our clients' time spent on accounting mainly by using our automated processes and integration to help increase their company efficiency at a minimum cost. SMEs can use TreezSoft to keep track of their expenses, accounts, daily operation e.g. Point of Sales (namely QPOS) system and etc.
Visit TreezSoft at https://www.treezsoft.com/ to sign up for a 30 days trial account with us!
You can also email us at [email protected] for more inquiries.