By: Gaurang S Trivedi, CFA
In order to better assess the true economics of the business and ascertain its value it is imperative that the off the balance sheet items are recorded in the books. This could be done by recording all contractual, guaranteed, contingent or at-risk amounts, that are either expected to be received or to be paid, into the books as an asset or liability with a corresponding contra-liability or asset account.
Consider accounting for operating lease transaction for example. Recording of a contractual Operating Lease arrangement could be done by creating Contra Accounts as
Operating Lease Asset on the asset side and
Operating Lease Obligation on the liability side
Periodic lease rental payments could be credited into
Lease Rental Payment
Periodic Amortization of Lease Asset and Obligation over contractual life of lease:
Operating Lease Obligation
Operating Lease Asset
The net impact is:
A progressive approach that explicitly recognizes assets available or liabilities assumed by the corporation.
Provides an objective basis to evaluate the effectiveness of transactions entered into by
managements by linking profits and charges associated with the underlying assets and liabilities respectively.
The contra accounts created have no bearing on profits or cashflow.
The contra asset and liability accounts created do not affect the book value.
Efficiency ratios such as Return on Assets and Asset Turnover will be depressed due to a higher asset base until the corresponding asset is fully amortized.
Debt ratios may be negatively affected if the contra liability is deemed a financing activity.
If the contra asset account is created as a reserve, the following differing effects may materialize:
Book Value will increase.
Debt Service ratios will not be affected.
Debt to Equity and Debt to Total Capital will be positively affected due to higher Equity Capital.
Return on Equity will be depressed due to a higher equity base until the corresponding reserve account is fully amortized.