Meaning: Off-balance Sheet Activity
Off-balance sheet activity is an activity that involves assets and liabilities which a company has no legal claims over; therefore, not inclusive of the company’s balance sheet. Items involved include loans and some indemnified facilities (Mikati, 2013). Off-balance-sheet activities boost the earnings ratios of companies involved at a higher rate than the use of on-balance sheet producing activities. Nonetheless, the volume of the kind of business undertaken does not affect the price of capital to assets ratios apart from risk-based capital ratios. For off-balance sheet activities to take root, there must be a regulatory necessity to protect banks that offer financial services for any kind of risk (Mikati, 2013). The risks involved are undetermined for the activities; therefore, a crucial form of assurance is necessary.
Types of Off-balance Sheet Items Found in Commercial Banks
The off-balance sheet activities that commercial banks can engage in are determined by the type of risk involved. Initially, there is an Interest Rate Future contract where the sale or purchase of fixed income assets is required. The cash inflows realized in the future are used to compensate for any market interest rate losses that arose during the period (Mikati, 2013).
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The second type is the swap contracts that majorly deal with swapping interest rates of the parties involved. The bank amends interest payment outflow between two sides, either from fixed to variable or variable to fixed rates of interest (Mikati, 2013). This contract reduces risk of interest rate since the duration of assets and liabilities is shortened. Third, banks use securitization, which is a process by which liquid bank assets are gathered and sold to third parties (Livingstone, 2011). The risk is also reduced in that the characteristics of securitization resemble a bond, making it easier to assess the risks arising.
Fourth, the bank may venture into loan commitment which consists of borrower and lender involving the terms and policies of giving and taking a certain amount of money. In most cases, commitments are in condition to maintain a sound financial position to the borrower. There is also the purchase of loans from banks, which is indicated as off-balance sheet until the sale is complete (Mikati, 2013). Revolving working capital is a commitment whose proceeds are used for construction, purchase of equipment or acquisition of other companies as assets. Use of commitments as a backup is also common in places such as commercial paper (Livingstone, 2011).
Moving an Off-balance Sheet Item onto the Balance Sheet
Assets as well as liabilities in off-balance sheet activities are transferred to the balance sheet by adjusting various accounts used to record them. For executor contracts, the financial statements should be adjusted to record assets and liabilities where operating leases are involved (Livingstone, 2011). Take-or-pay contracts appear in the balance sheet; the potential cash flow requirements are considered then analyzed. Company’s cash flows that operate with debt appear on the balance sheet only when financial statements are adjusted to recognize the assets and liabilities involved in that project.
Assessing the Risk of Off-balance Sheet Items
The risk of off-balance sheet items is assessed by measuring the difference between the rate of interest on sensitive assets and the rate of interest on liabilities in relation to the average price by the book value of equity (Mikati, 2013). First, because the credit risk affects loans, enormous differences in interest rates influence the market value of fixed rate assets. Capital adequacy, risk ensures that investors, creditors, and insurers are protected in the case of bank failure. The risk is assessed by dividing the book value of total capital by total assets. Third, there is liquidity risk that is depicted when the bank pays a premium over market value to finance their assets. The risk is significantly reduced if the bank holds current assets in large quantities (Livingstone, 2011). Leverage and operating cost, on the other hand, determines the real systemic risk when measured at a fixed cost.
In conclusion, although off-balance sheet activities are legal, accounting standards must be followed. The rules are very minimal and if at all, are used by investors and creditors; they can complicate their understanding and analyzing skill. Therefore, it is important to examine documents according to the accounting rules; and those analyzing should seek more disclosure from management and financial experts in place.
Livingstone, A. (2011). Exploring Off-balance Sheet Accounting and Fraudulent Accounting Practises Retrieved from http://www.newlearner.com/courses/hts/bat4m/pdf/Exploring%20Off-Balance%20Sheet%20Accounting.pdf
Mikati, N. (2013). Bank Risk Exposure, Bank Failure an Off Balance Sheet Activity : An Empirical Analysis for U.S. Commercial Banks. Retrieved from http://economix.fr/fr/recrutement/2014/jpo-2014/papier_Ziadeh.pdf
Pala. T. (2013). What Lies Beneath: How Off-balance Sheet Treatment can Hide the True Debt Picture. Retrieved from http://legalmca.com/2013/02/08/what-lies-beneath-how-off-balance-sheet-treatment-can-hide-the-true-debt-picture/