Off-balance sheet assets and liabilities are legal
Investors first need to realize that
off-balance-sheet items are not new, and have been in existence for many
years. Some of the high-profile cases in the news, that stretch the
accounting fabric to its limits, are highlighting to many first-generation
investors, the sophistication and complexities of business transactions.
Many routine transactions are handled
off-balance-sheet until the obligations have been met. For example,
unfulfilled executed purchase orders are not recorded until the merchandise
has been received. Standard employment contracts are usually recorded
through payroll when paid. Consulting contracts are normally accrued when
the services are rendered. These routine unrecorded extended term
obligations are common business practices, where future liabilities go
unreported as of a balance sheet date. Additionally, the whole area of
contingent liabilities is not recorded on the actual financial statements.
In most cases, these are “nice to know” items, but should not affect one’s
Operating leases, while disclosed and scheduled out,
are usually not recorded on the books until payments are due. Briefly,
operating leases are those leases where the risk of ownership stays with the
manufacturer or owner. The lessee does not record the asset, or the
liability, but records the expense when used or paid. In effect, operating
leases keep assets & debt off the balance sheet. Most office copier leases
are treated this way. They are expensed when paid, yet the contract may
extend out 3 to 5 years. Office leases are treated similarly. In some cases,
one can argue that the balance sheet is misleading, but investors should be
responsible enough to read the footnotes of the stocks they own.
Theoretically, an airline company can have a balance sheet showing no
airplanes as fixed assets and no associated debt. The rental obligations
would be disclosed and scheduled out in the operating lease footnote.
Investors need to realize that required operating lease payments should be
considered debt, regardless of their accounting classification. The
accounting profession and the government are reviewing the accounting for
Securitizations have become another area of potential
conflict. Companies structure them as both on-balance-sheet, as well as
off-balance-sheet transactions. For those unfamiliar with the term, it is
taking illiquid assets, in most cases accounts or notes receivable,
transferring them to an unconsolidated subsidiary, converting the assets
into securities and selling them off. In many cases the numbers are
material, especially for financial institutions. New comprehensive
disclosure rules in this area are being developed. Finance professionals
have been debating for years whether or not securitizations should be
treated as off-balance-sheet sales, or kept on the balance sheet.
Nevertheless, the concept, more commonly known as “mortgage backed
securities,” has been around since the depression,
The unconsolidated subsidiary issue needs to be
re-examined by the accounting profession. The basic accounting postulate of
the accounting entity concept makes it very clear that the entire business
entity should be reported, regardless of legal entity. The cook-book
approach to rule making has lost sight of the postulate. As accounting
reform unfolds, this area will most likely be fixed.
There are also off-balance sheet assets that should
be disclosed. For example, some finance companies have large balances of
billed but uncollected late charges, which historically are collected. These
items should be disclosed. Additionally, salvageable receivables
written-off, but with a high likelihood of recovery, should also be
The SEC’s new disclosure rules for off-balance-sheet
arrangements, should add value to investors.