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What is 'Off-Balance Sheet (OBS)'

Off-balance sheet (OBS) items refer to assets or liabilities that do not appear on a company's balance sheet.  Although not recorded on the balance sheet, they are still assets and liabilities of the company. Off-balance sheet items are typically those not owned by or are a direct obligation of the company. For example, when loans are securitized and sold off as investments, the secured debt is often kept off the bank's books. 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 when 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 often only appear in the accompanying notes.  Also, of concern is some off-balance sheet items have the potential to become hidden liabilities. For example, collateralized debt obligations (CDO) can become toxic assets, assets that can suddenly become almost completely illiquid, before investors are aware of the company's financial exposure.

Off-balance sheet items are not inherently intended to be deceptive or misleading. Certain 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 the risks and benefits of assets and liabilities with other companies, as in the case of joint venture (JV) 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 whose financial covenant condition stipulates 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 while legal ownership is retained by the separate entity. The company must only 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.

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