A balance sheet probably is one of the most crucial pieces of documents in the financial world, helping to give an idea of where a company stands financially at any given point in time. On the balance sheet, it lists assets, liabilities, and equity, but everything does not appear on the balance sheet. Some things are very essential for knowing about a company’s financial health. Some of those important items do not come out at all in the balance sheet.
What are they?
In this paper, we are going to discuss types of accounts and financial activities that do not directly find their way onto the balance sheet. We walk you through contingent liabilities, off-balance-sheet items, and many more. Let’s dig in and answer that question that’s probably been pressing for you: which account does not appear on the balance sheet?
1. Contingent Assets and Liabilities
Some accounts are excluded from the balance sheet. The contingent assets and liabilities fall within this category. It is potential as an asset or liability and requires the determination of a future event.
Contingent Liabilities
A contingent liability would arise for a company in case of an ongoing lawsuit. For example, if a company is liable to lose a lawsuit, then it may suffer a liability. A contingent asset would arise if the company was the litigant to be sued and could eventually be paid a settlement. These possibilities are not assured and are thus not represented on the balance sheet but instead in the footnotes of the financial statements.
For example, suppose an enterprise is a defendant in litigation alleging patent infringement. Its present value-what can potentially become a lost lawsuit or future settlement can neither recognize contingent liability nor asset because each of the parties could neither hope nor have any justification to believe that the judge will be favorable to either party’s claim.
2. Operating Leases
Generally, an operating lease is hardly ever reported in the balance sheet, especially in previous accounting standards. A new change in accounting, however, slowly but surely brings a direction of change in this practice. Under an operating lease, the lessee uses an asset. He does not assume ownership while owing the risks and rewards of ownership.
Old Accounting Standards:
Like under the old standards, as with IAS 17, operating leases are accounted for differently. No lease asset or liability on the balance sheet would be recognized; only lease payments-that are just a simple expense on the income statement term that is as “off-balance-sheet financing”.
New Accounting Standards:
Most leases must now be reported on the balance sheet as assets and liabilities under new rules such as IFRS 16 and ASC 842. This will better reflect the true nature of a company’s financial obligations. However, some short-term leases, usually less than 12 months, are exempt.
For example, suppose a firm rents office space for five years. Unless the new rules are adopted, that kind of lease would not appear on the balance sheet either as an asset or as a liability. Unless the new rules are adopted, however, such a lease would appear on the balance sheet as both an asset right to the use of the space and a matching liability obligation to pay for it.
3. Some Financial Instruments
Some of these sophisticated financial instruments, depending on some accounting principles, are not shown on the balance sheet. They include derivatives and securitizations, or some forms of off-balance-sheet financing arrangements.
Securitizations:
Securitization refers to the securitizing process, wherein other forms of assets, such as loans, mortgages, and many more, are all bunched into securities. There are structured products that would be considered financial arrangements but not part of the original company’s balance sheet. However, there are off-balance-sheet items of the firm that would be subject to various forms of financial risks.
Derivatives:
For instance, derivatives are made up of futures and options, and those could have been kept off the balance sheet only when specific preconditions were met. Today, with the increasing accounting standards as well as changed rules, most of the derivative instruments are now carried on the balance sheet.
For instance, an enterprise can create a holding SPV, through which the enterprise manages the debt so that it is not appearing on the balance sheet. It does not make its debt appear on the books but faces risk from that end.
4. Commitments and Obligations
Commitments are future obligations wherein a firm has agreed but not yet consummated the obligation. The common examples include contracts for the purchase of goods, services, or other businesses. Although these obligations pose a threat to the financial health of a company, they do not appear on the balance sheet unless they are realized through a transaction.
For example, an entity can negotiate a ten-year supply contract that guarantees it would gain the material needed for production. The organization would not list such an undertaking as a liability in the balance sheet unless and until the delivery of the goods takes place.
Committed are usually put in the footnotes of the financial statements as corporations would be offering other liabilities that will eventually arise later and therefore affect cash or profitability position.
5. Intangible Assets Not Acquired through Transaction
These intangibles include goodwill, brand value, and intellectual property and can only appear on the balance sheet if bought as part of a business acquisition. If a company takes a long period of time building brands or developing internal intellectual property, then its value is not reflected explicitly since it can often be one of the firm’s primary success drivers over a long period.
Internally generated intangibles
Internally-created goodwill or brand value, as in the form of a good reputation of the company, goes unrecorded unless purchased from another entity. The assets may carry much value, but they can never be entered on the balance sheet unless they are acquired.
Example: Consider a company that has spent decades developing a brand. The brand may be worth hundreds of billions of dollars in the market, but absent the acquisition of a competing brand or intellectual property as part of a transaction, it does not appear on the balance sheet.
6. Why Are These Items Kept Off the Balance Sheet?
Most of these items remain off the balance sheet either because they do not meet very strict criteria under accounting standards or due to past practices that averted certain risks of finances from being brought before the public’s eyes.
Sometimes, off-balance-sheet transactions or arrangements have been used shrewdly to present a cleaner picture or more preferred financial condition. In the case of operating leases, for example, corporations may avoid reporting liabilities that might make the company appear too indebted on paper.
However, off-balance-sheet items are crucial for two reasons, first, the increased transparency will no doubt impact the risk profile and future liabilities and therefore, the net financial health of the company. Of late, a new trend in accounting has developed. Off-balance-sheet items will require increased transparency via better footnotes and good disclosures.
7. Effects of Off-Balance Sheet Items
Although these accounts are not posted in the balance sheet, these accounts will dramatically influence how good the financial statement of a company might look. The best example is that of an entity whose financial future expenses in the future years would be heavier if those contingent liabilities become realities. Operating lease, though a commitment that will not appear in the balance sheet, is a liability that would occur in cash over time.
Example: One company may appear to be healthy on first look. It will have a low debt-to-equity ratio. But if a huge proportion of its liabilities is disguised in off-balance-sheet accounts like operating leases or contingent liabilities, the actual risk will be much more.
8. Off-Balance Sheet Items
This is as it attempts to reveal an evaluation of a company beyond the balance sheet. The footnotes and disclosures of off-balance-sheet items may provide more information and background. Such a view may be a more comprehensive one of the financial health of a company.
Important Note: To identify those items that would affect the financial position of a company, find footnotes in a financial statement that report off-balance-sheet items. Such disclosure is a must to ascertain the total picture of a firm’s financial commitments and risk exposures.
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Conclusion
Basically, the account that would appear on the balance sheet would depend on different factors from the nature of the account to the specific rules in accounting. Actually, from contingent assets and liabilities to certain financial instruments, commitments, and intangible assets, there are many things that affect the financial standing of a company but which do not appear on the balance sheet.
Such off-balance-sheet items may not be found on the face of the balance sheet but could still influence the health and future prospects of a firm. Investors, analysts, and other business professionals should sift through all disclosed information to ensure that they receive the right and proper view of the company’s financial position.
One of the analyses of a company’s financial statement is to understand which account does not appear on its balance sheet. Next time you go through some company’s financial statement remember that the balance sheet speaks only one side of the story and read the footnotes for a complete version of this company’s financial health.