Off-Balance Sheet Components

When a business files a financial report, some of its activities and components may not be included because they are off balance sheet (OBS). OBS components can be daughter companies, new ventures or letters of credit. Generally Accepted Accounting Principles (GAAP) allows for OBS components so risks can be compartmentalized and carried outside of a parent company. However, this can be abused if companies use OBS regulation to hide critical liabilities. It is important to look at OBS components in the footnotes of a financial report to gain a clear picture of a company's liabilities.

Off Balance Sheet Components

All companies must take on a level of risk in order to grow. Running a business in itself is a risk, and the risks get larger the bigger the business becomes. Successful businesses must take on new ventures in order to grow employee salaries and shareholder wealth. When they do this, they know there is a risk of failure, and they do not want to compromise their successful core business. As a result, they may form a subsidiary to take on the risk. If the risk fails to pay off, the subsidiary can declare bankruptcy without affecting the parent company's business.

Types of Components

Consider a magazine publishing company that would like to try its hand in television. The publicly traded company already has a large profit base, and it knows the new venture could be a great success or a great failure. In order to keep itself safe in this endeavor, it forms a child company to take on the television opportunity. This child company may be deeply in debt, and that debt is not reported on the parent company's balance sheet. If the television venture fails, the child declares bankruptcy. The parent company pays the legal fees for the bankruptcy and other costs, but it does not have the bankruptcy on its record.

Where to Components

Companies must list off balance sheet components in the footnotes of their financial reports. You will also find outstanding liabilities or assets in this section. For example, if a company knows it will lose $10,000 in a pending lawsuit, it will not enter that loss on this month's balance sheet, but it may be listed in the footnotes. All OBS components should also be listed, but GAAP is not as clear about what is mandatory in terms of footnotes, so companies do take liberties here.

Evaluating Components

OBS components have a bad reputation since they were abused by companies like Enron. OBS components, including operating leases, debt obligations and securitizations, all present significant risk to shareholders in a parent company. However, just having OBS components is not a bad thing. It is up to you to determine what risks the OBS components present to the bottom line for the parent company. You may also consider whether the risk is a viable undertaking or if it is too large for the potential payoff. Only an investor can make this decision; analysts may help in providing you with the data.

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