Question

1. Why do you think Lease accounting has evolved to the current state? What may be reasons why companies want to keep debt off the balance sheet?

Answer 1

In today’s world, leases appear far and wide; they are commonplace throughout the

business and accounting frontiers. Accounting for leases, however, is not so clear cut.

Since there are various ways to account for leases, many companies pick and choose

which they feel best suits their situation, even when this sweeps dirt under the rug along

the way. The financial procedures for dealing with leases should entail benefits as well as

limitations to ensure each company is fairly representing all of its financial information.

Off-balance sheet financing is one of the hot topics in accounting for leases because of

the implications it imposes on financial reporting. This thesis will discuss these

implications, as well as the continuing search for convergence of FASB and IASB as they

strive to make leases as transparent and honest as possible.

Off-balance sheet (OBS) items is a term for 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.

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, although they can be mis-used by bad actors to be deceptive. 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 sharethe risks and benefits of assets and liabilities with other companies, as in the case of joint venture (JV) projects.

What Is Off-Balance Sheet (OBS)?

Off-balance sheet (OBS) items is a term for 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.

Understanding Off-Balance Sheet

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, although they can be mis-used by bad actors to be deceptive. 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 sharethe risks and benefits of assets and liabilities with other companies, as in the case of joint venture (JV) projects.

The Enron scandal was one of the first developments to bring the use of off-balance-sheet entities to the public's attention. In Enron's case, the company would build an asset such as a power plant and immediately claim the projected profit on its books even though it hadn't made one dime from it. If the revenuefrom the power plant was less than the projected amount, instead of taking the loss, the company would then transfer these assets to an off-the-books corporation, where the loss would go unreported.

KEY TAKEAWAYS

• Off-balance sheet (OBS) items are an accounting practice whereby a company does not include a liability on its balance sheet.
• While not recorded on the balance sheet itself, these items are nevertheless assets and liabilities of the company.
• Off-balance sheet items can be used to keep debt-to-equity (D/E) and leverage ratios low, facilitating cheaper borrowing and preventing bond covenants from being breached.
• The practice of off-balance sheet financing has come under increasing scrutiny after a number of accounting scandals revealed the mis-use of the practice.

Types of Off-Balance Sheet Items

There are several ways to structure off-balance sheet items. The following is a short list of some of the most common:

Operating Lease

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.

Leaseback Agreements

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 Receivables

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