Off-balance sheet activities in corporate accounting

¶ … Balance Sheet Activities

Off-sheet balance activities are of particular interest to investors as well as the Financial Accounting Standards Board (FASB) because these accounts can be difficult to identify and track and, in some cases, can even represent hidden liabilities. The definition of an off-balance sheet item is simply one that is an asset or debt that does not appear directly on a company's financial statements (Investopedia, N.d.). One of the most common examples of an off-balance sheet activity generally comes in the form of an operating lease. The primary company in this scenario does not have a legal claim or responsibility for the property and they simply lease the property from a subsidiary operation that was created to handle the real estate needs of the primary operation.

One of the issues that is commonly present in such an arrangement deals with the terms of such arrangements. Since the two companies are often extremely closely related to one another, the terms of these off-balance sheet leases can often be manipulated for various accounting objectives. For example, if a company wanted to minimize the profitability of its primary operations for tax purposes, or any other objective, then it could have the subsidiary company overcharge the principle company, compared to what could be considered a fair market value, for leasing rights to any properties that the company holds. Furthermore, if the principle company wanted to maximize its profitability then it could make arrangements with the subsidiary company to underprice the value of the leases between the two separate organizations. Therefore, without full transparency regarding the terms of the lease as well as some information about the strategy being used in the lease design, it can be extremely difficult to get an accurate picture of the either of the company's actual financial performance or asset holdings.

Because the off-balance sheet accounts have historically been a source of accounting manipulation, either legally or illegally, they have been the target of increasingly stringent regulations. One major step towards addressing many of the concerns associated with the off-balance sheet transaction, especially in regards to lease arrangements, was provided by the passage of the Sarbanes-Oxley Act of 2002. The FASB offers an explanation for the changes in the existing accounting practices as (FASB, 2016):

"The previous accounting model for leases in GAAP and International Financial Reporting Standards (IFRS) did not require lessees to recognize the assets and liabilities arising from operating leases in accordance with FASB Concepts Statement No. 6, Elements of Financial Statements (and the IFRS's Conceptual Framework for Financial Reporting), but it did require lessees to recognize assets and liabilities arising from capital leases. The FASB, together with the IASB, initiated a joint project to improve the financial reporting of leasing activities in GAAP and IFRS in light of criticism that the previous accounting model for leases failed to meet the needs of users of financial statements."

Because of the previous regulations, in some cases the relationship between the leasers and the lessee would be recorded with totally different accounting systems that could be difficult for most observers to reconcile.