By LeaseCrunch® on November 29, 2022 at 6:00 AM
Back in the early 2000s, there was an energy-trading and utility company named Enron. Based out of Houston, Texas, this company is responsible for one of the most famous accounting frauds in history, and one of the jewels in their fraudulent crown was off-balance-sheet financing.
Although the company went bankrupt for their nefarious accounting practices, not all off-balance-sheet financing results in financial disaster, as long as an organization performs it the right way and stays compliant with lease accounting standards.
So what is off-balance-sheet financing? And what’s off-balance-sheet “fair game”?
What is the Meaning of Off-Balance-Sheet?
Off-balance-sheet, or OBS, is an accounting practice named aptly, for it is when an organization leaves an asset or a liability off of its balance sheet.
Sometimes this occurs because the Generally Accepted Accounting Principles (GAAP) don’t require the disclosure. The implementation of ASC 842 greatly narrows what can be properly left off the balance sheet. Before this new lease standard, the most common assets to be left off the balance sheet were operating leases, because operating leases of any length were not required to be included.
Organizations use off-balance-sheet financing because it can positively impact their level of debt and liability. However, it must be noted that although off-balance-sheet liabilities and assets are not recorded on the balance sheet, they are still technically assets and liabilities of an organization.
Why is Off-Balance-Sheet Financing Important?
Off–balance-sheet items are important to those interested in gaining a holistic picture of any organization’s financial health. However, off–balance-sheet liabilities and assets can be difficult to find, as they may only be disclosed in the accompanying notes to financial statements.
Organizations should pay attention to committed future payments that are off–balance sheet, because these financial obligations could overwhelm an organization, rendering them unable to pay. Even where off–balance-sheet financing is compliant with GAAP, this practice makes it more difficult to gain a holistic idea of an organization’s total commitments.
What are Examples of Off-Balance-Sheet Items?
Because of the new lease accounting standard, the only type of operating lease allowed to be an off–balance-sheet lease is an operating lease with a term that is less than 12 months duration. In this case, the lessee only records lease payments as an expense on the income statement instead of listing the asset and liability.
In a leaseback agreement, a company sells an asset to another company and then leases it from that other company. This allows the lessee to keep this full asset off the balance sheet and instead only include the right-of-use (ROU) asset and lease liability on the books. Organizations often use this to provide positive cashflow at the time of the sale.
Accounts Receivable (A/R)
This category includes funds that haven’t been received from a company’s customers, so the possibility of default is higher.
For A/R, instead of recording a large and potentially uncollectible asset on their balance sheet some companies opt to sell their A/R asset to another company (called a factor) to pass the risk off to them. The factor company, who now “owns” the asset, pays the original company a percentage of the total value of all A/R upfront and takes care of collecting payments on these high-risk payments from the customers. After the customer pays, the factor remits the balance to the original company, minus a collection fee.
This is a way for businesses to collect the money owed to them while mitigating their collection risk.
Lease Accounting Software for Off-Balance-Sheet Financing
With the new lease standard reducing opportunities for off–balance-sheet financing, lease accounting becomes even more complicated, resulting in a higher risk for errors.
Lease accounting software, like LeaseCrunch, helps organizations cut back on time and errors when it comes to their lease accounting. For compliance with the new standard, LeaseCrunch saves organizations time and effort for even just one lease.
What is the difference between on-balance-sheet financing and off-balance-sheet financing?
The difference between off–balance-sheet financing and on-balance-sheet financing is quite simple: Off–balance-sheet financing means a company leaves an asset or liability off their financial statement (although still giving mention of it in the notes), and on-balance-sheet financing means a company accounts for an asset or liability on their financial statement.
Is off-balance-sheet financing legal?
Yes, off–balance-sheet financing is completely legal, as long as it is done in accordance with the GAAP and DEC requirements by disclosing off-balance-sheet financing in financial statement notes.
What does OBS mean in accounting?
OBS is an acronym that stands for “off–balance-sheet financing.”