Let’s talk about out-of-balance accounts in accounting

3. Out-of-balance accounts and transactions in depth

Let us look at the most common out-of-balance transactions:

a) Setting up a subsidiary with further sale of controlling interest to investors. Such a sale may allow a parent company to generate extra profits and remove unattractive or risky operations from its balance sheet. For example, a real estate construction company might separate its riskier oversees business from its main more secure activities in its homeland.

b) Participating in joint ventures or special purpose entities (SPEs) with high credit in order to obtain cheaper financing. To tackle the issue, FASB has actively worked out new directions on when a company should consolidate a special purpose entity, or add it to the parent company’s balance sheet.

c) Operating leases. Due to the fact that accounting for operating leases under current rules may be misleading to investors, FASB is working on a new accounting standard which would require recording such operating lease assets on the balance sheet.

d) Selling receivables under factoring. In case a company wishes to improve its liquidity or increase quality of its account receivables, it may sell accounts receivable to a third party (factor). It should be mentioned that out-of-balance accounting in that case may only be used if the risks and rewards are substantially transferred, which is usually indicated by no a recourse deal (if the factor fails to recover debts it cannot recover its losses from the selling company) or the selling company has no right to further payments from the factor.

e) Sale and lease back arrangements. Release of liquid funds in the short run may be achieved by the sale of fixed assets to a financial institution with the subsequent lease of that property back. However, if the arrangement in substance is a secured loan rather than an actual sale, the company should not use the out-of-balance method of recording it, and the sold assets still get recorded on the balance sheet.

f) Investments in repo agreements. Repo agreements deal with the sale of securities to a bank and its subsequent repurchase within a short period of time. By nature, the company receives the loan from the bank backed by securities. Usually, the initially sold security is repurchased at a slightly higher price, therefore it is considered to be a loan exposure and interest.

g) Pledged assets. Usually, upon providing a loan to a company a bank requires proper collateral. It does not have ownership of those pledged assets unless a default occurs. Therefore, banks account for collateral received on respective out-of-balance accounts, while commercial companies carry their pledged assets on the balance sheet.

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