Off-balance sheet (OBS) refers to assets or liabilities that do not appear on a company's balance sheet. Although the OBS accounting method can be used in a number of scenarios, this accounting practice is especially useful for sheltering a company's financial statements from the impact of asset ownership and its corresponding liability.
Large asset purchases are often funded with debt financing, but too much debt can make a company less desirable to investors and lenders. Using the off-balance-sheet method for these types of assets can help businesses maintain appealing leverage ratios.
Some of the most common OBS assets are operating leases, leaseback agreements and accounts receivable.
An OBS operating lease is one in which the lessor retains the leased asset on its balance sheet. The company leasing the asset only accounts for the monthly rental payments and other fees associated with the rental rather than listing the asset and corresponding liability on its own balance sheet.
At the end of the lease term, the lessee generally has the opportunity to purchase the asset at a drastically reduced price.
Under a leaseback agreement, a company can sell an asset, such as a piece of property, to another entity. They may then lease that same property back from the new owner.
Like an operating lease, the company only lists the rental expenses on its balance sheet, while the asset itself is listed on the balance sheet of the owning business.
Accounts receivable (AR) represents a considerable liability for many companies. This asset category is reserved for funds that have not yet been received from customers, so the possibility of default is high.
Instead of listing this risk-laden asset on its own balance sheet, companies can essentially sell this asset to another company, called a factor, which then acquires the risk associated with the asset. The factor pays the company a percentage of the total value of all AR upfront and takes care of collection. Once customers have paid up, the factor pays the company the balance due minus a fee for services rendered. In this way, a business can collect what is owed while outsourcing the risk of default.