Off-balance sheet (OBS), or Incognito Leverage, usually means an asset or debt or financing activity not on the company's balance sheet. Total return swaps are an example of an off-balance sheet item.
Some companies may have significant amounts of off-balance sheet assets and liabilities. For example, financial institutions often offer asset management or brokerage services to their clients. The assets managed or brokered as part of these offered services (often securities) usually belong to the individual clients directly or in trust, although the company provides management, depository or other services to the client. The company itself has no direct claim to the assets, so it does not record them on its balance sheet (they are off-balance sheet assets), while usually has some basic fiduciary duties with respect to the client. Financial institutions may report off-balance sheet items in their accounting statements formally, and may also refer to "assets under management," a figure that may include on and off-balance sheet items.
Under current accounting rules both in the United States (US GAAP) and internationally (IFRS), operating leases are off-balance-sheet financing. Financial obligations of unconsolidated subsidiaries (because they are not wholly owned by the parent) may also be off-balance sheet. Such obligations were part of the accounting fraud at Enron.
The formal accounting distinction between on and off-balance sheet items can be quite detailed and will depend to some degree on management judgments, but in general terms, an item should appear on the company's balance sheet if it is an asset or liability that the company owns or is legally responsible for; uncertain assets or liabilities must also meet tests of being probable, measurable and meaningful. For example, a company that is being sued for damages would not include the potential legal liability on its balance sheet until a legal judgment against it is likely and the amount of the judgment can be estimated; if the amount at risk is small, it may not appear on the company's accounts until a judgment is rendered.
DIFFERENCE BETWEEN ON AND OFF-BALANCE SHEET
Traditionally, banks lend to borrowers under tight lending standards, keep loans on their balance sheets and retain credit risk—the risk that borrowers will default (be unable to repay interest and principal as specified in the loan contract). In contrast, securitization enables banks to remove loans from balance sheets and transfer the credit risk associated with those loans. Therefore, two types of items are of interest: on-balance sheet and off-balance sheet. The former is represented by traditional loans, since banks indicate loans on the asset side of their balance sheets. However, securitized loans are represented off the balance sheet, because securitization involves selling the loans to a third party (the loan originator and the borrower being the first two parties). Banks disclose details of securitized assets only in notes to their financial statements.
HOW IT WORKS
For example, let's assume that Company XYZ has a 3,392,000 € line of credit with Bank ABC. The line of credit comes with a financial covenant that requires Company XYZ to stay below a 0.5 debt-to-equity ratio at all times. Company XYZ wants to buy a new piece of equipment. The new machine costs 848,000 €, but Company XYZ does not have the cash to make the purchase. If it uses debt to buy it, the company will violate the covenant on its line of credit. Therefore, Company XYZ needs to find another way to obtain a the machine.
To solve the problem, Company XYZ creates a separate entity that will purchase the equipment and then lease it to Company XYZ via an operating lease. This way, even though Company XYZ has virtually complete control of and responsibility for the machine, it only records its monthly lease expense on its income statement; it does not have to record the additional debt on its balance sheet, and it does not record an increase in assets (because it does not legally own the equipment). XYZ used off-balance-sheet financing to acquire an asset without having to record the transaction as such on its balance sheet.
FACTORING
Factoring is the process in which a business receives an advance on its accounts receivable from a third party, the “factor,” at a discount. The business sells its invoices in return for a cash injection of between 70 and 90 percent of the total invoice value. The advantage for a small or start-up business is that it provides and immediate boost to cash flow. As no liability has been created, the business does not have to report the factoring on its balance sheet. However, factoring reduces profit margins and the company’s scope for future borrowing.
OPERATING LEASES
Many small businesses lease real estate and equipment as part of their operations. The lessee reports the lease expenses – such as rental and insurance – on his income statement, but his balance sheet is unaffected. The asset's value and liabilities remain on the lessor’s (owner’s) balance sheet. The lessee returns the asset to the lessor at the end of the lease.
CAPITAL LEASES
A capital lease allows the lessor to assume a proportion of an asset’s ownership and enjoy some of its benefits. If the lease rental payments’ present value is 75 percent or more of the asset’s value, the asset and liability must be recorded on the lessee’s balance sheet. If the rental payments amount to less than 75 percent of the asset’s value, they do not need to be recorded on the lessor’s balance sheet. In July 2011, the International Accounting Standards Board and its U.S. sister organization, the Financial Accounting Standards Board suggested that the difference between operating and capital lease should be abolished. The organizations proposed that all lease asset values and liabilities be added to the lessee’s balance sheet.
LETTER OF CREDIT
Letters of credit provide a secure method for small business exporters to obtain payments for goods and services. A bank issues a letter of credit and guarantees the payment for goods contracted by a buyer from a seller. The bank assumes the seller’s risk that the buyer will not pay for the goods. The buyer pays a fee to the bank for the service, usually about 1 percent of the contract value. In the process, the seller shifts the non-payment liability from his balance sheet to the bank.
INTEREST RATE SWAPS
Interest-rate swaps are financial derivatives that involve the exchange of a cash flow based on fixed interest rates for one based on floating interest rates in the same currency. Small companies with poor credit ratings use interest rate swaps to arrange funding at a fixed interest rate for a long-term investment, and to hedge their debt obligations. The two parties agree to swap cash flows on specific dates, called settlement dates, over a period of time, called settlement time. The credit exposure of each party in the chain is difficult to value, but it remains off the balance sheet as no equity is created
WHY IT MATTERS
Other examples of off-balance-sheet financing includes the sale of receivables under certain conditions, guarantees or letters of credit, joint ventures, or research and development activities. Often, companies set up special-purpose vehicles (SPVs) or special-purpose entities (SPEs) that have their own balance sheets, and companies then place the assets or liabilities in question on the SPEs' balance sheets.
Off-balance-sheet financing is most often used in order to comply with financial covenants. However, companies also use off-balance-sheet financing to preserve borrowing capacity (for example, when a company is close to hitting its limit on a borrowing line or would like to use its borrowing line for something else), lower their borrowing rates, or manage risk. The strategy, however, has had a bad reputation since it was famously used by former energy giant Enron.
It very important to note that off-balance-sheet financing transactions are not invisible, as many people believe. Rather, the Securities and Exchange Commission (SEC) and generally accepted accounting principles (GAAP) require companies to disclose these and other financing arrangements in the notes to their financial statements. Savvy investors know to look at these notes for information and insight. Additionally, GAAP rules are very particular regarding how to record off-balance-sheet items, and managers who do not know these rules or do not apply these rules properly can face considerable consequences.
OFF-BALANCE SHEET ACCOUNTING AND MANIPULATION METHODS
With off-balance sheet accounting, a company didn't have to include certain assets and liabilities in its balance sheet -- it was "off-sheet" and therefore not part of their financial statements. We'll talk more later about how the Sarbanes-Oxley Act changed this practice. While there are legitimate reasons for off-balance-sheet accounting, it is often used to make a company look like it has far less debt than it actually does. Some types of off-balance-sheet accounting move debt to a newly created company specifically for that purpose, which was the case with Enron. These are called special purpose entities (SPEs) and are also known as variable interest entities (VIEs).
Off-balance-sheet entities can be created for several reasons, such as when a company needs to finance a business venture but doesn't want to take on the risk, or when there is too much debt to get a loan. By starting a new SPE, they can secure a loan through the new entity. There are situations where it makes sense to start an SPE. If your company wants to branch out into another area outside of its core business, an SPE will keep that risk from affecting the main balance sheet and profitability of the company. Prior to 2003, a company could own up to 97 percent of an SPE without having to report the liabilities of the SPE on its balance sheet.
SYNTHETIC LEASES
Synthetic leases often use SPEs to hold title to a company's property and lease that property back to the company. Because of off-balance-sheet accounting, synthetic leases allowed companies to reap the tax benefits of ownership without having to list it as a liability on their balance sheets.
Synthetic leases could also be signed with some entity other than an SPE. Banks, for example, would often purchase property for businesses and lease it back to them via a synthetic lease. The company leasing the property avoids the liability on the balance sheet but still gets to deduct interest and depreciation from its tax bill.
Some companies may have significant amounts of off-balance sheet assets and liabilities. For example, financial institutions often offer asset management or brokerage services to their clients. The assets managed or brokered as part of these offered services (often securities) usually belong to the individual clients directly or in trust, although the company provides management, depository or other services to the client. The company itself has no direct claim to the assets, so it does not record them on its balance sheet (they are off-balance sheet assets), while usually has some basic fiduciary duties with respect to the client. Financial institutions may report off-balance sheet items in their accounting statements formally, and may also refer to "assets under management," a figure that may include on and off-balance sheet items.
Under current accounting rules both in the United States (US GAAP) and internationally (IFRS), operating leases are off-balance-sheet financing. Financial obligations of unconsolidated subsidiaries (because they are not wholly owned by the parent) may also be off-balance sheet. Such obligations were part of the accounting fraud at Enron.
The formal accounting distinction between on and off-balance sheet items can be quite detailed and will depend to some degree on management judgments, but in general terms, an item should appear on the company's balance sheet if it is an asset or liability that the company owns or is legally responsible for; uncertain assets or liabilities must also meet tests of being probable, measurable and meaningful. For example, a company that is being sued for damages would not include the potential legal liability on its balance sheet until a legal judgment against it is likely and the amount of the judgment can be estimated; if the amount at risk is small, it may not appear on the company's accounts until a judgment is rendered.
DIFFERENCE BETWEEN ON AND OFF-BALANCE SHEET
Traditionally, banks lend to borrowers under tight lending standards, keep loans on their balance sheets and retain credit risk—the risk that borrowers will default (be unable to repay interest and principal as specified in the loan contract). In contrast, securitization enables banks to remove loans from balance sheets and transfer the credit risk associated with those loans. Therefore, two types of items are of interest: on-balance sheet and off-balance sheet. The former is represented by traditional loans, since banks indicate loans on the asset side of their balance sheets. However, securitized loans are represented off the balance sheet, because securitization involves selling the loans to a third party (the loan originator and the borrower being the first two parties). Banks disclose details of securitized assets only in notes to their financial statements.
HOW IT WORKS
For example, let's assume that Company XYZ has a 3,392,000 € line of credit with Bank ABC. The line of credit comes with a financial covenant that requires Company XYZ to stay below a 0.5 debt-to-equity ratio at all times. Company XYZ wants to buy a new piece of equipment. The new machine costs 848,000 €, but Company XYZ does not have the cash to make the purchase. If it uses debt to buy it, the company will violate the covenant on its line of credit. Therefore, Company XYZ needs to find another way to obtain a the machine.
To solve the problem, Company XYZ creates a separate entity that will purchase the equipment and then lease it to Company XYZ via an operating lease. This way, even though Company XYZ has virtually complete control of and responsibility for the machine, it only records its monthly lease expense on its income statement; it does not have to record the additional debt on its balance sheet, and it does not record an increase in assets (because it does not legally own the equipment). XYZ used off-balance-sheet financing to acquire an asset without having to record the transaction as such on its balance sheet.
FACTORING
Factoring is the process in which a business receives an advance on its accounts receivable from a third party, the “factor,” at a discount. The business sells its invoices in return for a cash injection of between 70 and 90 percent of the total invoice value. The advantage for a small or start-up business is that it provides and immediate boost to cash flow. As no liability has been created, the business does not have to report the factoring on its balance sheet. However, factoring reduces profit margins and the company’s scope for future borrowing.
OPERATING LEASES
Many small businesses lease real estate and equipment as part of their operations. The lessee reports the lease expenses – such as rental and insurance – on his income statement, but his balance sheet is unaffected. The asset's value and liabilities remain on the lessor’s (owner’s) balance sheet. The lessee returns the asset to the lessor at the end of the lease.
CAPITAL LEASES
A capital lease allows the lessor to assume a proportion of an asset’s ownership and enjoy some of its benefits. If the lease rental payments’ present value is 75 percent or more of the asset’s value, the asset and liability must be recorded on the lessee’s balance sheet. If the rental payments amount to less than 75 percent of the asset’s value, they do not need to be recorded on the lessor’s balance sheet. In July 2011, the International Accounting Standards Board and its U.S. sister organization, the Financial Accounting Standards Board suggested that the difference between operating and capital lease should be abolished. The organizations proposed that all lease asset values and liabilities be added to the lessee’s balance sheet.
LETTER OF CREDIT
Letters of credit provide a secure method for small business exporters to obtain payments for goods and services. A bank issues a letter of credit and guarantees the payment for goods contracted by a buyer from a seller. The bank assumes the seller’s risk that the buyer will not pay for the goods. The buyer pays a fee to the bank for the service, usually about 1 percent of the contract value. In the process, the seller shifts the non-payment liability from his balance sheet to the bank.
INTEREST RATE SWAPS
Interest-rate swaps are financial derivatives that involve the exchange of a cash flow based on fixed interest rates for one based on floating interest rates in the same currency. Small companies with poor credit ratings use interest rate swaps to arrange funding at a fixed interest rate for a long-term investment, and to hedge their debt obligations. The two parties agree to swap cash flows on specific dates, called settlement dates, over a period of time, called settlement time. The credit exposure of each party in the chain is difficult to value, but it remains off the balance sheet as no equity is created
WHY IT MATTERS
Other examples of off-balance-sheet financing includes the sale of receivables under certain conditions, guarantees or letters of credit, joint ventures, or research and development activities. Often, companies set up special-purpose vehicles (SPVs) or special-purpose entities (SPEs) that have their own balance sheets, and companies then place the assets or liabilities in question on the SPEs' balance sheets.
Off-balance-sheet financing is most often used in order to comply with financial covenants. However, companies also use off-balance-sheet financing to preserve borrowing capacity (for example, when a company is close to hitting its limit on a borrowing line or would like to use its borrowing line for something else), lower their borrowing rates, or manage risk. The strategy, however, has had a bad reputation since it was famously used by former energy giant Enron.
It very important to note that off-balance-sheet financing transactions are not invisible, as many people believe. Rather, the Securities and Exchange Commission (SEC) and generally accepted accounting principles (GAAP) require companies to disclose these and other financing arrangements in the notes to their financial statements. Savvy investors know to look at these notes for information and insight. Additionally, GAAP rules are very particular regarding how to record off-balance-sheet items, and managers who do not know these rules or do not apply these rules properly can face considerable consequences.
OFF-BALANCE SHEET ACCOUNTING AND MANIPULATION METHODS
With off-balance sheet accounting, a company didn't have to include certain assets and liabilities in its balance sheet -- it was "off-sheet" and therefore not part of their financial statements. We'll talk more later about how the Sarbanes-Oxley Act changed this practice. While there are legitimate reasons for off-balance-sheet accounting, it is often used to make a company look like it has far less debt than it actually does. Some types of off-balance-sheet accounting move debt to a newly created company specifically for that purpose, which was the case with Enron. These are called special purpose entities (SPEs) and are also known as variable interest entities (VIEs).
Off-balance-sheet entities can be created for several reasons, such as when a company needs to finance a business venture but doesn't want to take on the risk, or when there is too much debt to get a loan. By starting a new SPE, they can secure a loan through the new entity. There are situations where it makes sense to start an SPE. If your company wants to branch out into another area outside of its core business, an SPE will keep that risk from affecting the main balance sheet and profitability of the company. Prior to 2003, a company could own up to 97 percent of an SPE without having to report the liabilities of the SPE on its balance sheet.
SYNTHETIC LEASES
Synthetic leases often use SPEs to hold title to a company's property and lease that property back to the company. Because of off-balance-sheet accounting, synthetic leases allowed companies to reap the tax benefits of ownership without having to list it as a liability on their balance sheets.
Synthetic leases could also be signed with some entity other than an SPE. Banks, for example, would often purchase property for businesses and lease it back to them via a synthetic lease. The company leasing the property avoids the liability on the balance sheet but still gets to deduct interest and depreciation from its tax bill.