Off-Balance-Sheet Items - Essay Example

OFF-BALANCE-SHEET ITEMS By Date (Number of words 1304) Introduction Off-balance sheet activities are part of an intriguing part of financial statements. Presented as footnotes to the financial statements, these contingent items have a vital economic impact on the future rather than the present financial prospects of a business. However, this economic impact is not easy to interpret or discover at a glance of the financial statements. Off-balance-sheet-items are financial obligations or rights a company does not report on its balance sheet even though they have a substantial effect on the financial activities of a company such as the case of Enron (Bauman, 2003). Off-balance-sheet-financing is that debt that is not usually reported on a company’s balance sheet. The formal distinction between off and on-balance sheet items present some complications that are usually subject to some level of judgment by management. However, the primary distinction between the off and on-balance sheet items is based on whether or not a business/company owns or is legally responsible for that debt. Additionally, uncertain liabilities or assets are subject to being grouped as ‘probable’, ‘meaningful’ and ‘measurable’. Some of the examples of the off-balance sheet items include; unconsolidated subsidiaries, operating leases, financial instruments such as hedging contracts and derivatives securities, contingent assets/liabilities among many others (Bauman, 2003). Economic Substance Financial statements need to be adjusted from time to time so that they are able to reflect the economic substance of the information they represent. Companies should, therefore, focus on accounting methods that emphasis on economic substance by considering changes in accounting policies. Economic substance is a transaction that has a purpose besides reducing tax liability. Conversely, Sally and Schreiber states that, “The economic substance doctrine is a common law judicial doctrine that disallows tax benefits of a transaction if the transaction lacks economic substance or a business purpose.” Therefore, transactions and events should be accounted for in a manner that faithfully represents their true economic substance and not the mere legal form. The off-balance sheet items; thus, provide a reason financial statements often fail to faithfully represent the economic substance. Impact and Implications of Off-Balance Items Off-balance sheet activities usually do not represent the true picture of a net worth of a firm. This is because firms do not include market values of their off balance sheet items. Furthermore, the transparency of off balance sheet activities are usually affected because accounts are opaque (Torre & Hamilton, 2009). This can be attributed due to the following reasons; off-balance sheet activities are usually harder to track because their full information is usually not provided and thus, can be used in hiding a company’s debts/liabilities and assets. Moreover, losses may not be appropriately reported and ROCE and gearing may be distorted; thus, failing to disclose the future financial obligations of a company (Bauman, 2003). For this reason, off-balance sheet items do not, therefore, depict the true financial position of a company. Derivatives Derivatives contracts may greatly impact on the performances of firms in diverse ways. Firstly, financial derivative tools play a great role in stabilization of banks/firms. Used by banks as the end-users for hedging tools, derivatives can decrease risks of financial institutions while enhancing their performance through reduction of volatility of any underlying assets even though they can also have a negative impact on their performance. However, the impact of the derivatives contacts on a firms’ riskiness differs according to the purpose behind holding of such contracts (Mills, & Newberry, 2005). Operating Lease One of the advantages of an operating lease is their ability to be used as a form of off-balance sheet financing. However, they also attract much confusion in equal measure. For instance, when a company acquires an asset through debt financing, usually the liability shows up in its balance sheets (financial statements) thereby alerting or informing investors of future claims from the company’s benefits/income. However, when an asset is leased, no liability is created even though a company has entered into a lease agreement and is legally obligated to make lease payments in future. For instance, Bouvier (2011) argues that, “Ratings agencies and finance textbooks agree that long-term lease obligations represent debt, regardless of the accounting treatment” (p. 3). Moreover, the current FASB standards require that operating leases should be disclosed in financial statements. However, judging from the notes alone, it’s hard and difficult to accurately estimate the operating lease obligations of a company and hence, their economic substance. Thus, given that operating leases are usually used on a short-term basis as opposed to their overall “useful life of the asset” they, therefore, fail to faithfully reflect the economic substance of a company because they do not transfer any of the rewards or risks of ownership to the lessee. Additionally, liability is not usually recognized on a lessee’s financial statements (balance sheet) even though the lessee has a financial obligation of paying an agreed amount in future (Lozano-Vivas & Pasiouras, 2014). Accountants and committee members worldwide agree that accounting for leases should be consistent because such information is fundamental to the users of the financial statements (Bauman, 2003). However, it is unmistakably clear that accounting for the leases has presently been plagued with a multitude of detrimental loopholes that induces many schemes of shrewd management in thwarting the spirit and intent of the standards of lease accounting. Unconsolidated Subsidiary Unconsolidated subsidiary is another example of off-balance sheet items. However, this fails to faithfully represent the economic substance of both the subsidiary and parent company; especially when a parent company is not required to consolidate it is financial statements and those of the subsidiary for purposes of reporting, irrespective of the fact that parent companies are obligated to pay for unconsolidated subsidiaries’ liabilities; thus, failing to reflect the economic substance of such transactions on financial statements (Bauman, 2003). It is imperative to note that under both the current accounting rules of the IFRS and the US GAAP, financial obligations of unconsolidated subsidiaries can be classified as off-balance sheet items. These obligations represent some of the accounting frauds that happened at Enron (Miller & Bahnson, 2010) In general terms, items should appear on a firm’s/company’s balance sheet if they are liabilities or assets that a firm owns or is legally responsible for. However, “the unconsolidated” subsidiaries may be recorded as off-balance sheet. Therefore, the financial obligations of the unconsolidated subsidiaries may be recorded off the balance sheet of a parent company. Uncertain liabilities or assets need not to be recorded on the financial statements (balance sheet) either. Assets or liabilities are “certain” if the duly meet the test of being measurable, probable and meaningful (Casu, & Girardone, 2005). For instance, a company that is being sued for damages would not include potential legal liability on its balance sheet until a legal judgment against it, is probable and the judgment amount can be estimated. Companies can use off-balance sheet items for legitimate purposes such as; separating riskier business activities from more secure business activities. However, some businesses use it for illegitimate purpose such as hiding debt of a company from public scrutiny such as Enron and Lehamn Brothers companies. Conclusion Ultimately, it is evident companies have used OBS activities irresponsibly and responsibly over the years. For this reason, “Abusive” off-balance sheet accounting was one of the major causes of the financial crisis witnessed in the country and globally. Moreover, it was through off-balance sheet accounting that the spread of the securitizations, bad loans, and the derivative transactions was enhanced leading to almost a total collapse of the financial system. Therefore, judging from the above, it’s, therefore, true to say that off-balance sheet items have led to unfaithful presentation of financial statements because many firms are hiding their debts. Ultimately, if companies can use off balance sheet items such as derivatives, operating leases and unconsolidated subsidiaries for legitimate reasons, off balance sheet items can be great a tools for facilitating financing. Bibliography Bouvier, S., 2011. IASB, FASB hear concerns about hybrid approach to lessor accounting. Accounting Policy and Practice Report, 7(1), 29-30. Burkholder, S., 2011, JANUARY. FASB members indicate leas accounting proposal not a done deal at rules forums. Accounting Policy & Practice Report, 7(2), 62-63. Bauman, M. P., 2003. The impact and valuation of off-balance-sheet activities concealed by equity method accounting. Accounting Horizons, 17(4), 303-314. Casu, B., & Girardone, C., 2005. An analysis of the relevance of off-balance sheet items in explaining productivity change in European banking. Applied Financial Economics, 15(15), 1053-1061. Lozano-Vivas, A., & Pasiouras, F., 2014. Bank productivity change and off-balance-sheet activities across different levels of economic development. Journal of Financial Services Research, 46(3), 271-294. Lozano-Vivas, A., & Pasiouras, F., 2014. Bank productivity change and off-balance-sheet activities across different levels of economic development. Journal of Financial Services Research, 46(3), 271-294. Miller, P., & Bahnson, P., 2010, OCTOBER. Off-balance-sheet financing: Holy grail or holey pail? Accounting Today, 24(13), 16-17. Miller, P., & Bahnson, P., 2010. Reprise: off-balance-sheet financing is dysfunctional. Accounting Today, 23(14), 16-17. Mills, L. F., & Newberry, K. J., 2005. Firms Off‐Balance Sheet and Hybrid Debt Financing: Evidence from Their Book‐Tax Reporting Differences. Journal of Accounting Research, 43(2), 251-282. Sally P. Schreiber, J.D., 2014, Oct. 9. Notice defines terms for economic substance doctrine. Retrieved from http://journalofaccountancy.com/news/2014/oct/201411106.html Torre, I., & Hamilton, B., 2009. Creative accounting. New York, NY: Palgrave Macmillian. Read More