Off-balance sheet refers to the business activities that are not shown on the balance sheet of a company. These activities can be assets, debts, or financing activities that are not directly reported on the balance sheet but can still have a significant impact on the company’s financial status and risk profile.
Companies often use off-balance sheet activities for legitimate purposes such as securitizing assets, leasing assets, or entering into joint venture agreements. For example, a company may sell its receivables (the money owed by its customers) to a third party. This allows the company to get immediate cash and transfer the risk of non-payment, but it also means that the receivables (and the associated risk) will not appear on the company’s balance sheet.
However, off-balance sheet activities can also be misused to hide debts or to make a company appear financially stronger than it actually is. For example, a company might create a special purpose entity (SPE) to hold debt, making the company’s own balance sheet look less leveraged.
Off-balance sheet items can significantly impact a company’s level of risk and financial stability, so it’s important for investors and analysts to take them into account when evaluating a company’s financial health. Regulations and accounting standards, like those set by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), have tightened to require more disclosure of off-balance sheet activities following financial scandals and crises.
Example of Off-Balance Sheet
Let’s take a look at a common example of an off-balance sheet activity: leasing.
Consider a company, let’s call it AutoCo, that needs a fleet of cars for its operations. Instead of purchasing these vehicles outright (which would be a significant capital expenditure and would appear on the balance sheet as an asset and corresponding liability), AutoCo decides to lease the vehicles.
In an operating lease agreement, the lessor retains the ownership of the cars, and AutoCo simply makes periodic lease payments. These lease payments are reported on the income statement as an operating expense, but the leased cars are not reported on AutoCo’s balance sheet because AutoCo does not own them.
This way, AutoCo gets the use of the cars it needs without having to report a large asset purchase and corresponding liability on its balance sheet. This could make AutoCo appear less leveraged or indebted than it might if it had purchased the vehicles outright.
However, it’s important to note that accounting rules have changed in recent years to require more lease obligations to be reported on the balance sheet. This is in part due to concerns that significant liabilities related to leases were being hidden off the balance sheet, making companies look financially healthier than they actually were.
That said, there are still various kinds of commitments and contingencies (like certain types of guarantees or derivative contracts) that can remain off-balance sheet, and can significantly impact a company’s risk profile. That’s why it’s important for investors to look carefully at the notes to a company’s financial statements, where information about off-balance sheet activities is typically disclosed.