Off-balance sheet liabilities in a small business

Off-balance sheet liabilities are accounts that many SMB searchers and investors may not have heard about before. For one, many businesses do not have off-balance sheet liabilities. Two, off-balance sheet liabilities are exactly what they say, off a company's balance sheet. Therefore, disclosures are the main way for searchers & investors to learn about off-balance sheet liabilities. This blog post looks to delineate what an off-balance sheet liability is, what are common off-balance sheet liabilities and their importance when buying a small business.

What does it mean for a Liability to be Off-Balance Sheet?

An off-balance sheet liability does not appear on a company’s balance sheet. In general, there are two reasons a liability may be “off-balance sheet”:

1. Incidental Off-balance Sheet Liabilities

For many small businesses, if an item isn’t obviously classified as an accounts payable, credit card account, or long-term loan, the bookkeeper may simply not know or want to classify it as a formal liability. This is common with pending litigation or guarantees to customers, where the bookkeeper does not have the controls in place to appropriately account for them as libilities.

2. Intentional Off-balance Sheet Liabilities

On the other hand, some liabilities may be intentionally moved off the balance sheet to lower a business’s debt-to-equity ratio or make the business appear more robust. The line between savvy accounting and fraud can get gray – see Enron.

Companies want lower leverage ratios because it allows them an opportunity to gain access to cheaper financing (i.e., interest rates on future debt will be lower). In dire situations, lower leverage ratios allow a company to not break its negative debt covenants. If those covenants are not met then creditors can force the company into bankruptcy.

Now that we have a solid understanding of what off-balance sheet liabilities are and why a company may want them, let’s move on to some common examples of off-balance sheet liabilities.

What are Common Off-Balance Sheet Liabilities in Small Businesses?

Common off-balance sheet liabilities:

• lease agreements 

• guarantees

• pending litigation 

Before 2018, companies that leased equipment, machinery, buildings, etc. would recognize these leases as operating leases because accounting rules and regulations (under US GAAP) allowed operating leases to be classified as off-balance sheet liabilities. Therefore, only the rental expense paid each year would be in the income statement. 

After 2018, regulators came together and stated that most of those operating leases would be considered an on-balance sheet liability. Nowadays, it is rare to see operating leases considered an off-balance sheet liability. Typically if the operating lease is an off-balance sheet liability it is short term (less than a year) and there is no contractual indication of renewal.

Guarantees are classified as off-balance sheet liabilities and arise when a parent company guarantees the debt of a subsidiary or Special-Purpose Vehicle (SPV). In other words, the parent company is not responsible for the debt; however, if the SPV or subsidiary defaults and can’t make payments then that debt is required to be paid off by the parent company.

Lastly, pending litigation is considered an off-balance sheet liability because in the future it is possible for the company to pay to settle litigation charges. Once the pending litigation is probable and reasonably estimated then it moves to the balance sheet. Therefore, the pending litigation is a liability because the company is required by law to settle the litigation charges.

After reviewing common off-balance sheet liabilities, one must ask, where are these off-balance sheet liabilities located in the financial statements?

Where are Off-Balance Sheet Liabilities Located?

In larger businesses with more established financial reporting, off-balance sheet liabilities may be detailed in the firm's financial statements. The details are found within the disclosure section of those financial statements. However, many small businesses will not have robust financial statements, much less a disclosure section.

Because of this, small business buyers and investors often include an analysis of off-balance sheet liabilities in the due-diligence process prior to acquiring the business.

This due diligence will include conversations with the business’s accountant and bookkeepers as well as a review of material agreements, such as leases for property or equipment and agreements with customers.

Why is it Important to Understand these Liabilities when Buying a Business?

As a small business investor, it is important to understand the off-balance sheet liabilities of a prospective business because those off-balance sheet liabilities could easily turn to balance sheet liabilities. Once those liabilities are on the balance sheet, the small business investor will be fully responsible for that liability.

Unplanned for liabilities could seriously impact a business’s cashflow and thereby hurt the returns for investors and potentially impede an SMB buyer from meeting their debt obligations.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.