Letís talk about out-of-balance accounts in accounting
May 21, 2015
Out-of-balance items play an important role in the determination of the financial health of a company. Being harder to track, they can become hidden traps aimed to artificially improve the companyís financial position and performance.†In this article we will describe the main types of out-of-balance transactions and provide approaches to accounting for the most common ones.
Out-of-balance accounts are simply accounts that are not used for the preparation of the balance sheet. Generally, a company does not have any legal claim or responsibility for the out-of-balance items.
The most common example is an operating lease arrangement. In order to illustrate the application of the out-of-balance items, let us assume that Company ABC (a fictitious entity) rents an office building under operating lease terms. Although the office building is an asset that brings economic benefits to the entity, under the operating lease terms it is not accounted for on the balance sheet. Instead, the rent charge is expensed to the income statement. The approach affects important accounting ratios such as return on assets (net income earned on each dollar invested in the companyís assets). If compared to an alike-sized company possessing its own office building, it will look like the return on assets of Company ABC is better, which is misleading.
The use of the out-of-balance accounts is permitted under US GAAP; however, it is very important to account for those transactions correctly. A company may get into trouble if it manipulates the out-of-balance accounts in order to look better than it actually is.
The following are the main reasons for fraudulent reporting involving out-of-balance accounts:
- To comply with the financial covenants;
- To obtain additional financing or negotiate lower finance costs;
- To reduce its financial or operational risks.
Currently, in order to assist investors in making informed decisions, companies are obliged to disclose out-of-balance arrangements in the to financial statements.