Off-balance sheet items refer to those assets and liabilities that aren’t shown on a balance sheet. However, these assets and liabilities still belong to the company though they may not be directly associated with the company.
Companies use this method of accounting to lessen the impact of ownership of certain assets and obligations of certain liabilities on their financial statements. The company keeps certain items off of its balance sheet to present a stronger balance sheet to the investors.
The company is able to do so 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.
This doesn’t mean that leaving these items off of the balance sheet is done for misleading investors or any other deceptive purposes. These items can still be disclosed in the notes given in the financial statements.
Some off-balance sheet items are:
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.
The asset is not shown on the company’s balance sheet. Typically, at the end of the lease term, the lessee has the option of purchasing the asset.
Accounts receivables can also be off-balance sheet items. Almost all companies have this asset category and the default risk of this asset is the highest.
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.
Another example of off-balance sheet items would be when investment management firms don’t show the clients’ investments and assets on the balance sheet.
Other examples of off-balance sheet items include guarantees or letters of credit, joint ventures, or research and development activities.
Let’s take a look at a situation where a company may decide to opt for off-balance-sheet financing. Suppose the company wants to buy new equipment but they don’t have the funds to be able to purchase that equipment.
If the company decides to take a loan, it would lead to a debt-to-equity ratio that will look extremely off to its investors. So the company decides to lease the equipment from another entity. This will be called an operating lease.
This way the company won’t have to show an asset or a liability on their balance sheet and will just have to account for the monthly rental payments made.
The monthly rental expense will be shown in the income statement and the company would have successfully kept this asset, or a possible liability if they had borrowed the funds, off the balance sheet.
Companies must follow the rules laid out by SEC (Securities and Exchange Commission) and GAAP (generally accepted accounting principles) when disclosing off-balance sheet items in the notes.
These notes are necessary for investors when they’re analyzing the financial situation of the company.