Off-balance sheet arrangements: Overview, definition, and example
What are off-balance sheet arrangements?
Off-balance sheet arrangements refer to financial transactions or obligations that do not appear directly on a company’s balance sheet. These arrangements are typically used to keep liabilities or assets off the balance sheet, often to improve the company's financial appearance by avoiding the immediate impact on reported debt or assets. Off-balance sheet arrangements can take many forms, including operating leases, joint ventures, or special purpose entities (SPEs). These are generally disclosed in the notes to financial statements but are not included in the balance sheet itself, which makes it important for investors and stakeholders to carefully examine all disclosures.
For example, a company may enter into a lease agreement for office space, where it rents the space rather than owning it. The lease payments are recorded as an expense, but the leased property is not listed as an asset on the balance sheet.
Why are off-balance sheet arrangements important?
Off-balance sheet arrangements are important because they can affect a company’s perceived financial health and risk profile. By keeping certain liabilities or assets off the balance sheet, a company may appear less leveraged and have stronger financial ratios, which can make it more attractive to investors and creditors. However, this practice can also obscure the true financial condition of a company, which may pose risks for stakeholders who rely on financial statements for decision-making. It is important for investors and analysts to understand these arrangements and consider their potential impact on a company’s future financial performance.
Understanding off-balance sheet arrangements through an example
Let’s say a company enters into a long-term lease agreement for equipment. Instead of recording the equipment as an asset on its balance sheet, the company treats the lease as an operating lease. The lease payments are considered an operating expense, and the equipment is not shown as part of the company’s assets. This arrangement allows the company to avoid showing the full liability of the lease on its balance sheet, which can improve financial ratios such as return on assets or leverage.
In another example, a company may set up a special purpose entity (SPE) to hold certain assets or liabilities. The SPE’s financials are not consolidated with the parent company’s balance sheet, which can be a way for the company to avoid reporting the full debt or financial obligations associated with the SPE’s activities.
An example of an off-balance sheet arrangements clause
Here’s how an off-balance sheet arrangements clause might appear in a financial agreement or disclosure:
“The Company has entered into several off-balance sheet arrangements, including operating leases and joint ventures, as disclosed in the notes to the financial statements. These arrangements are not included on the Company’s balance sheet but may impact its future financial obligations.”
Conclusion
Off-balance sheet arrangements allow companies to manage their financial reporting in a way that can improve certain financial metrics, such as reducing the appearance of debt or liabilities. However, they also require careful consideration and full disclosure to ensure transparency. While these arrangements can offer financial flexibility, they can also obscure a company’s true financial position if not properly disclosed or understood. Investors and stakeholders must be aware of the potential implications of off-balance sheet arrangements when evaluating a company’s financial health.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.