Off balance sheet definition
/What is Off Balance Sheet?
Off balance sheet refers to those assets and liabilities not appearing on an entity's balance sheet, but which nonetheless effectively belong to the enterprise. These items are usually associated with the sharing of risk or they are financing transactions. Off balance sheet liabilities are a particular concern, since they might eventually result in substantial liabilities for and payments by the reporting entity.
A business tries to keep certain assets and liabilities off its balance sheet in order to present to the investment community a cleaner balance sheet than would otherwise be the case. It does so by engaging in transactions that are designed to shift the legal ownership of certain transactions to other entities. Or, the transactions are designed to sidestep the reporting requirements of the applicable accounting framework, such as GAAP or IFRS. There has been a general trend in the formulation of accounting standards to allow fewer and fewer off balance sheet transactions. For example, a recent revision to the leasing standards now requires the recordation of an asset in use for certain types of lease obligations that previously would not have appeared in the balance sheet.
Types of Off Balance Sheet Activities
There are several specific types of activities that do not appear on a reporting entity’s balance sheet. The most common types are as follows:
Special purpose entities (SPEs). These are legally separate entities created by a company to isolate financial risk and carry out specific activities. Companies often use SPEs to keep certain assets and liabilities off their own balance sheet, such as in securitization or project financing.
Factoring of receivables. In factoring, a company sells its accounts receivable to a third party (a factor) for immediate cash. If the sale is without recourse, the receivables and related risk are not shown on the company's balance sheet. This improves liquidity metrics but can obscure the true financial obligations and earnings potential.
Loan commitments and guarantees. Banks and financial institutions may issue loan commitments or financial guarantees that do not appear as liabilities until the funds are drawn. These are potential obligations that can affect financial health if exercised. Disclosures are usually made in footnotes, but not always on the main balance sheet.
Derivatives and hedging instruments. Some derivative contracts, like forward contracts or interest rate swaps, may not be recorded as assets or liabilities at inception, depending on accounting treatment. Their fair value might be disclosed in notes rather than directly on the balance sheet. Because they can carry significant risk, this can mask exposure if not properly monitored.
Securitization of assets. Securitization involves bundling assets like loans or receivables and selling them to investors through a special purpose vehicle. This removes the assets from the company’s balance sheet and can reduce reported debt or improve capital ratios. However, the company may still retain some risk or responsibility, which must be disclosed.
Presentation of Off Balance Sheet Transactions
Though off balance sheet assets and liabilities do not appear on the balance sheet, they may still be noted within the accompanying financial statement footnotes. This method of presentation is less favorable to the reader of a set of financial statements, since the issuer could bury the applicable information deep in the footnotes or use obscure wording to mask the nature of the underlying transactions. Consequently, the disclosure of off balance sheet transactions within a set of financial statements can be considered a red flag, warning of the presence of financial chicanery.