Off-Balance Sheet Obligations

Off-balance sheet (OBS) obligations, aka Incognito Leverage, usually refers to a material corporate asset or debt or financing activity not listed on the company's balance sheet, because the company is not required to do that by GAAP/IFRS.

This is one more situation when GAAP becomes BAAP because it allows the corporate management to mislead shareholders – and get away with it. For example, financial obligations of unconsolidated subsidiaries (because they are not wholly owned by the parent) may be kept off-balance sheet. Such obligations were part of the accounting fraud at Enron. Many of the energy traders' problems stemmed from setting up inappropriate off-balance-sheet entities.

Essentially, OBS is a form of financing in which large capital expenditures are kept off of a company's balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep their debt to equity (D/E) and leverage ratios low, especially if the inclusion of a large expenditure would break negative debt covenants.

Operating leases are one of the most common forms of off-balance-sheet financing. In these cases, the asset itself is kept on the lessor's balance sheet, and the lessee reports only the required rental expense for use of the asset.

Unlike capital lease, an operating lease is a lease whose term is short compared to the useful life of the asset or piece of equipment (an airliner, a ship, etc.) being leased. Thus, for example, an aircraft which has an economic life of 25 years may be leased to an airline for 5 years on an operating lease.

Keeping operating lease obligations off your balance sheet is misleading, because it understates the amount of your long-term liability by the total sum of leasing payments for the duration of the lease. Which must be quite substantial if equipment leasing is the core of your financial strategy. Therefore, you must disclose all operating leasing contracts and your resulting obligations at least in footnotes to your financial statement.

And, obviously, you have to make sure that your investment project financed by operating leasing makes financial and economic sense and is acceptable. Using the solid financial valuation model supported by all relevant documentation, of course.