Off balance sheet finance can be describes as a way of accounting items in the financial statements where assets, debts and other financing activities are found to be excluded from the balance sheet. These items may include a lease, a separate subsidiary or a conditional liability. Off balance sheet finance also involves excluding items like loan commitments, futures, forwards and other derivatives irrespective of derivatives relating to equity securities.
Financial analysis has stopped using the traditional balance sheet in assessing the risks and returns of a firm because many companies today are using off balance sheet finance (Finnerty 1998, p. 16). For example, financial institutions give asset management services or brokerage services often to their customers. The customers are granted ownership of the securities directly or in trust. The financial institution only provides management and depository services to the customer.
The company does not have any claim on the assets and may report the assets under management to increase the value of assets in the balance sheet. The institutions will report such items wrongly in the balance sheet to reduce the amount of debt. Off balance sheet Items It is evident that, items that should be reported in the balance sheet are assets or liabilities that are formally owned or legally accountable by the company. However, for an item to appear on the balance sheet, some times depends on the judgment of the management.
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According to Dye (2002), any uncertain asset in the balance sheet should be probable, measurable and meaningful. For example, a company being sued for damages will not incorporate the probable legal liability in the balance sheet unless a legal opinion has been passed against it. In addition another example is the banking industry where banks may have significant amounts in the off balance sheet accounts and it is difficult to differentiate these accounts.
A customer may deposit a million dollars in the bank deposit account regularly then the bank has liability of one dollar million. If the customer transfers that amount to an account in the money market mutual fund which is supported by the same bank, then the one million dollar is held as a trust for the customer and not a liability for the bank. If the bank uses the money to buy stock, the stock will be owned by the customer as well and cannot appear as an asset in the balance sheet of the bank as either an asset or a liability.
Regulation of companies for the use off balance sheet entries Off balance sheet finance can also be termed as synthetic leases in the sense that companies use regulations from different systems like tax and financial regulations for the purpose of accounting for an asset in an unusual way. For example, a company that leases property from another company does not legally own that property. The leasing company (lessor) will maintain the asset in its balance sheet while the lessee will record the lease as a liability in its balance sheet.
Many companies do not account for the payment of rent on lease on property in the balance sheet but in the real sense, a deduction of such a rent should be made in the books (Bowman 1980, p. 239). Many companies operate with off balance sheet finance where large capital expenditures are not recorded in the company’s balance sheet in the required classification methods. Companies take the advantage of using off balance sheet finance to keep their debt to equity ratio as well as leverage ratios at the minimum particularly when the company has large amounts of expenditure that might break negative debt covenants.
Items in the off balance sheet include joint ventures, research and development partnerships as well as operating leases. It is evident that many companies use operating leases as the most common type of off balance sheet finance. The companies (lessors) keep the asset on the balance sheet while the lessees report the rental expense incurred in the use of the asset. There are numerous set of regulations that have been set by the generally accepted accounting principles of the U. S regarding accounting for leases.
The rules give clear guidelines on whether leases should be capitalized or expensed (Finnerty 1998, p.24). Off balance sheet finance involves the urgent payment of invoices of a company to get rid of order debt from the balance sheet. It is a very easy and efficient way of eliminating book debt from the balance sheet. Off balance sheet finance helps a business to receive instant payments for invoices and this reduces the debt on the balance sheet. Off balance sheet entities can be used by companies responsibly or irresponsibly. Companies were allowed to use off balance sheet entities by the generally accepted accounting principles and the tax laws.
This was for the purpose of enabling businesses to finance their ventures through the transfer of risk of the ventures from the parent to the subsidiary off balance sheet. Investors who were not in need of investing in the ventures also benefitted from those regulations. As advocated by Engel et al (1999, p. 253), off balance sheet entities can be classified as good or bad depending on the effect they have on the entity. The generally accepted accounting principles allow entries in the off balance sheet to be excluded from the main financial statements but must be disclosed as footnotes at the end of the balance sheet.
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