Celestila Moonn, an UMB Global Affairs major student registered for the online G

Question

Celestila Moonn, an UMB Global Affairs major student registered for the online Global Financial Markets course.However, Moonn was not sure if a company's assets and/or liabilities that can be excluded from its financial statements. In order to make the concept clear, she sought help from a friend, an UMB MBA student. Her friend tells the following regarding off-balance-sheet activity However, Moonn needs your help. An off-balance-sheet activity is a transaction, contract, or commitment that a bank enters into but is not directly accounted for on the bank's balance sheet. They are often reported in the notes to the financial statement or on a separate schedule. Examples of these are letters of credit, lines of credit, options, forwards, and swaps. Briefly share your understanding of an off-balance-sheet activity with Moonn. Due on March 31 at 10pm

Explanation / Answer

Off balance sheet (OBS) items consists of those assets as well as liabilities that do not appear on a company’s balance sheet. Those assets of which a company is not the recognized legal owner and those liabilities of which a company does not have direct legal responsibility for are treated as OBS items.

Take the case of a banking entity. When a bank provides loan to its customers then the bank is the owner of the receivables from the loan and hence it will be shown as assets in the bank’s balance sheet. But when the bank selects to securitize its loans and then sells it off then it will be kept off the bank’s balance sheet.

An off balance sheet activity that I would like to discuss here is operating leases. Suppose that there is a company called Orange Computers and this company has a $10 million line of credit with Bank of Manhattan. Orange Customers want to buy an equipment and it cannot make use of debt to buy the equipment as it will led to violation of its covenant with regards to line of credit with Bank of Manhattan. In this case Orange Computers floats a separate entity. This separate entity buys the equipment and then leases to Orange Computers through an operating lease. Thus, even though Orange has a complete control over the equipment, it is not the recognized legal owner of the equipment. It cannot report the equipment on its balance sheet as the equipment has been purchased by it using off balance sheet financing.

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