What is an 'Off Balance Sheet - OBS'
Off balance sheet (OBS) items refer to assets or liabilities that do not appear on a company's balance sheet but that are nonetheless effectively assets or liabilities of the company. Assets or liabilities designated off balance sheet are typically ones that a company is not the recognized legal owner of, or in the case of a liability, does not have direct legal responsibility for. As an example, although loans issued by a bank are ordinarily kept on the bank's balance sheet, when some loans are securitized and sold off as investments, that securitized debt will be kept off the bank's books, and an operating lease is one of the most common off-balance items.
BREAKING DOWN 'Off Balance Sheet - OBS'Off balance sheet items are an important concern for investors in regard to assessing a company's financial health. Off balance sheet items are often difficult to identify and track within a company's financial statements because they usually only appear in the accompanying notes. Another concern is that some off balance sheet items have the potential to become hidden liabilities. For example, collateralized debt obligations (CDO), where assets that make up the CDO are debt obligations, can become toxic assets — ones that can suddenly become almost completely illiquid — before investors are aware of the company's financial exposure, because the CDOs are off balance sheet items.
Off balance sheet items are not inherently intended to be deceptive or misleading to investors. Certain types of businesses routinely keep substantial off balance sheet items. For example, investment management firms are required to keep clients' investments and assets off balance sheet. For most companies, off balance sheet items exist in relation to financing, enabling the company to maintain compliance with existing financial covenants. Off balance sheet items are also used to share both risks and benefits of assets and liabilities with other companies, as in the case of joint venture projects.
How Off Balance Sheet Financing Works
An operating lease, used in off balance sheet financing, is a good example of a common off balance sheet item. Assume that a company has an established line of credit with a bank and that a financial covenant condition for the bank extending credit is that the company must maintain its debt-to-assets ratio below a specified level. Taking on additional debt to finance the purchase of new computer hardware would violate the line of credit covenant by raising the debt-to-assets ratio above the maximum specified level.
The company solves its financing problem by using a subsidiary or special purpose entity (SPE), which purchases the hardware and then leases it to the company through an operating lease, a contract allowing use of the equipment, while legal ownership is retained by the separate entity. The company only has to record the lease expense on its financial statements. Even though it effectively controls the purchased equipment, the company does not have to recognize additional debt nor list the equipment as an asset on its balance sheet.