Off-balance sheet liabilities in a small business
By Mainshares
Dec 1, 2023
In Buying a 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.
Get the latest in your inbox
Join our bi-weekly SMB newsletter. It's free and not annoying.
This website (the “Website”) is owned and operated by Mainshares, LLC (“Mainshares”). By accessing the Website and any pages thereof, you agree to be bound by Mainshares’ Terms of Service and Privacy Policy, as well as the Terms of Service and Privacy Policy for Main Street Securities, LLC (“Main Street”). The information contained herein is provided for informational purposes only and is not intended to influence any investment decision or be a recommendation for any investment, service, product, or other advice of any kind, and shall not constitute or imply an offer of any kind. The products and services offered by Mainshares are not offered by a certified public accountant (“CPA”) and should not be considered as a substitute for services provided by a CPA.
The information contained herein is provided by Mainshares, LLC (“Mainshares”) for informational purposes only and is not intended to influence any investment decision or be a recommendation for any investment, service, product, or other advice of any kind, and shall not constitute or imply an offer of any kind. The products and services offered by Mainshares are not offered by a certified public accountant (“CPA”) and should not be considered as a substitute for services provided by a CPA.
Broker-dealer services provided in connection with some of the investment opportunities on the Mainshares platform are offered through Main Street, a registered broker-dealer, affiliate of Mainshares, and member of FINRA/SIPC. For additional information, please contact your licensed securities representative of Main Street Securities LLC or visit FINRA’s BrokerCheck. If the investment opportunity does not include the "Brokered by Main Street Securities" designation, broker-dealer services were not provided in connection with the offering through Main Street.
Neither Mainshares nor Main Street Securities LLC make investment recommendations and no communication, through this Website or in any other medium should be construed as a recommendation for any security offered.
Should you be presented with an investment opportunity, such investment opportunities involve private, unregistered securities that are speculative and involve substantial risk. These investment opportunities are conducted in accordance with an exemption from registration, specifically relying on the private offering provision outlined in Section 4(a)(2) of the Securities Act of 1933, along with compliance with Rule 506 of Regulation D. All investments involve risk and the past performance of a security, or financial product does not guarantee future results or returns. There is always potential to lose money when you invest in securities or other financial products. Private placements lack liquidity and distributions are not guaranteed. You are strongly encouraged to seek professional advice prior to entering into any transaction for any securities and to consider your investment objectives and risks carefully before investing.
Neither the SEC nor any federal or state securities commission or regulatory authority has recommended or approved any investment or the accuracy or completeness of any of the information or materials provided herein or through any references/links herein. There can be no assurance that any valuations provided by issuers are accurate or in agreement with market or industry valuations. Neither Mainshares nor Main Street Securities LLC make any representations or warranties as to the accuracy of such information.