An off-balance sheet (OBS) refers to items such as assets and liabilities that are not included on a company’s balance sheet.
Want to know more about what to include on your balance sheet? Check out our blog on everything small business owners need to know about balance sheets.
Although these items do not appear on the balance sheet, they are assets and liabilities of the business. The reason they do not have to report these items on the balance sheet is that there is no equity or debt linked to them.
Off-balance sheet items, also referred to as incognito leverage means that the company itself does not have a direct claim to the assets so it does not record them on the balance sheet. The items are owned or claimed by an external source.
The benefits of off-balance sheet financing
Off-balance sheet financing has some benefits as it does not negatively affect the financial overview of the company. Loans will generally negatively affect a company’s reports, making investors less likely to take an interest in the business.
The use of off-balance sheet items will not affect the reports, and therefore not affect the funding potential for the business.
Off-balance sheet items generally pose little risk to the company, as they are owned by an external source. For instance, taking out a lease on an item, instead of a loan to purchase an item transfers the risk to an external party, and does not have any long-term risk for the company.
In this case, the company can receive the item they need without raising it’s debt burden, allowing the company to use it’s borrowing funds for something else.
The disadvantages of off-balance sheet financing
The use of off-balance sheet financing can potentially be used to mislead investors, financial institutions, and other financing entities to believe that the company is in a better financial position than they actually are.
There have been several laws and regulations implemented to ensure that this practice is used correctly. Because of the potential for misleading information, investors and financial institutions often ask for more information than what’s on the balance sheet to ensure that they have a full overview of the company’s financial status.
Off-balance sheet financing is a legitimate, legal accounting practice, as long as the rules surrounding it are followed.
What are the differences between on and off-balance sheet items?
Put simply, on-balance sheet items are items that are recorded on a company’s balance sheet. Off-balance sheet items are not recorded on a company’s balance sheet.
(On) Balance sheet items are considered assets or liabilities of a company, and can affect the financial overview of the business.
Off-balance sheet items, however, are not considered assets or liabilities as they are owned or claimed by an external source, and do not affect the financial position of the business.
Examples of off-balance sheet items
Let’s say a company requires a new piece of machinery. Instead of purchasing the machinery, the company may decide to lease it from an external source so that it will not become an asset or liability, and will not need to be recorded on the balance sheet.
Another example is accounts receivable (AR), where there is a risk of default from the customer. A company may sell this asset to another company who takes on the collection and risk associated with it, for a fee or percentage of the AR collected.
Total return swaps are a type of credit derivative that can be an off-balance sheet item. Financial institutions regularly use this form of financing. Total return swaps are generally bonds and loans in which all of the risk is transferred to the receiver, so that the receiver has access to the asset immediately, in exchange for the risk.
