Question

Provide 5 examples of "off book" financial transactions on which SOX requires you to report if material. Please put some explanation for these.

Answer 1

Off book transactions refers to the assets, debts or financing activities that are not presented on the balance sheet of an entity.

Off book transactions allows an entity to borrow being without affecting calculations of measures of indebtedness such as debt to equity (D/E) and leverage ratios low. Such financing is usually used when the borrowing of additional debt may break a debt covenant. The benefit of off balance sheet items is that they do not adversely affect the liquidity position of an entity.

Off book transactions are in contrast to loans, debt and equity, which do appear on the balance sheet. Most commonly known examples of off-balance-sheet items include partnerships, joint ventures, and operating leases, capital leases, factoring, letter of credit.

Operating Leases

Many small businesses lease real estate and equipment as part of their operations. The lessee reports the lease expenses – such as rental and insurance – on his income statement, but his balance sheet is unaffected. The asset's value and liabilities remain on the lessor’s (owner’s) balance sheet. The lessee returns the asset to the lessor at the end of the lease.

Capital Leases

A capital lease allows the lessor to assume a proportion of an asset’s ownership and enjoy some of its benefits. Under U.S. accounting rules, as of publication, if the lease rental payments’ present value is 75 percent or more of the asset’s value, the asset and liability must be recorded on the lessee’s balance sheet. If the rental payments amount to less than 75 percent of the asset’s value, they do not need to be recorded on the lessor’s balance sheet. In July 2011, the International Accounting Standards Board and its U.S. sister organization, the Financial Accounting Standards Board suggested that the difference between operating and capital lease should be abolished. The organizations proposed that all lease asset values and liabilities be added to the lessee’s balance sheet.

Factoring

Factoring is the process in which a business receives an advance on its accounts receivable from a third party, the “factor,” at a discount. The business sells its invoices in return for a cash injection of between 70 and 90 percent of the total invoice value. The advantage for a small or start-up business is that it provides and immediate boost to cash flow. As no liability has been created, the business does not have to report the factoring on its balance sheet. However, factoring reduces profit margins and the company’s scope for future borrowing.

Letters of Credit

Letters of credit provide a secure method for small business exporters to obtain payments for goods and services. A bank issues a letter of credit and guarantees the payment for goods contracted by a buyer from a seller. The bank assumes the seller’s risk that the buyer will not pay for the goods. The buyer pays a fee to the bank for the service, usually about 1 percent of the contract value. In the process, the seller shifts the non-payment liability from his balance sheet to the bank.

Partnership

A partnership is a form of business where two or more people share ownership, as well as the responsibility for managing the company and the income or losses the business generates. That income is paid to partners, who then claim it on their personal tax returns – the business is not taxed separately, as corporations are, on its profits or losses.