1.What is Off Balance Sheet Commitments (OBSC)?
A legally binding agreement involving obligation to be satisfied in future. The obligation is termed as commitment that could be demandable in the future. So here we are talking about commitments by the entity that are legally enforceable and is demandable in future. In other words, it is future obligation (not present obligation that can be treated as a Liability).
Off Balance Sheet means transactions that are not recorded on the company’s statement of financial position. These indicate transactions of future (not past events recorded in accounts).
In a nutshell, the OBSC is the future liability to be honoured and measured in monetary terms. It is subject to analysis considering IFRS disclosure requirement and contacts terms along with future business scenario.
2.Why we should report Off Balance Sheet Commitments (OBSC)?
• IAS 1, paragraph 114 states: An entity normally presents notes in the following order, to assist users to understand the financial statements and to compare them with financial statements of other entities: (a) statement of compliance with IFRSs, (b) summary of significant accounting policies applied, (c) supporting information for items presented in the statements of financial position and in the statement(s) of profit or loss and other comprehensive income, and in the statements of changes in equity and of cash flows, in the order in which each statement and each line item is presented; and (d) other disclosures, including: contingent liabilities (see IAS 37) and unrecognized contractual commitments, and non-financial disclosures, e.g. the entity’s financial risk management objectives and policies (see IFRS 7).
• IAS 16, paragraph 74(c) states: The financial statements shall also disclose ..…the existence and amounts of restrictions on title, and property, plant and equipment pledged as security for liabilities; ..…the amount of contractual commitments for the acquisition of property, plant and equipment.
• IAS 38, paragraph 122(e) states: An entity shall also disclose: the amount of contractual commitments for the acquisition of intangible assets.
• IAS 40, paragraph 75(h) states: An entity shall disclose: contractual obligations to purchase, construct or develop investment property or for repairs, maintenance or enhancements.
• IFRS7, Financial instruments: Disclosures: paragraph 39 states: An entity shall disclose: a maturity analysis for non-derivative financial liabilities (including issued financial guarantee contracts) that shows the remaining contractual maturities. (Note that firm commitments meet the definition of a financial liability – a contractual obligation to deliver cash or another financial asset to another entity). Further, paragraph B11D states: The contractual amounts disclosed in the maturity analyses as required by paragraph 39(a) and (b) are the contractual undiscounted cash flows, for example: gross finance lease obligations (before deducting finance charges); prices specified in forward agreements to purchase financial assets for cash….; and gross loan commitments.
• IAS17 / IFRS16, Leases.
[For details Listing of IFRS, please check: https://www.ifrs.org/issued-standards/list-of-standards/ ]
3.What Process should we follow?
The reporting entity should evaluate every contract it has signed to ascertain Off Balance Sheet Commitments (OBSC). The documents that may be evaluated include, but not limited to (1) Purchase Orders (2) Service Contracts (3) Leases (4) Sales Contracts (5) Merger or Acquisition agreements (6) Loan or guarantee agreement (7) Collateral (8) Supply Contracts (9) Warranty (10) Letter of Intent (LOI) etc.
The documents should be evaluated to determine (1) existence of potential commitment (2) financial implication of the obligation (3) applicability as an Off Balance Sheet Item on the reporting date.
The process will always require a proper coordination with Contract cell, Purchasing Dept. (SCM team), Legal Dept. by the Accounting Dept. (Financial Reporting team) in order to accumulate the data and report it.
In case of reporting for the consolidated accounts of the group we should eliminate (not to consider) intercompany commitments between subsidiaries. Hence commitments to third party, joint ventures and associates (equity method investments) should be reported.
4.How should we evaluate the contracts?
Possible clauses that need to be evaluated in a contract document include:
o Non-cancellable clause in the contract
o Minimum trade quantity for purchase or sale
o Minimum level of service
o Penalty clause in the contract
o Exit value contracts (minimum payment by the buyer if the buyer terminate the contract)
o Take or Pay contracts (where the buyer agrees to pay for contracted products or services whether or not it orders or takes delivery)
o Guarantee (formal acceptance of responsibility for a debt or obligation)
o Warranty (generally related to integrity of product)
o Firm commitment
5.Contracts that should not be reported as OBSC?
Following are examples of items that should not be reported as Off Balance Sheet Commitments:
o Cancellable contracts (at no cost or obligation)
o Credit limit to customers’ that are not of committing nature
o On Balance Sheet Items – Liabilities that are reported on the Statement of Financial Position (Present Obligation arising out of past events)
o Contracts or cover having no committing character
o In case of group reporting, intercompany commitments within subsidiaries (last para of the point no. 3 supra)
o Contracts providing any right not any obligation (right to receive=asset & obligation to pay=liability)
6.Where and How to disclose the OBSC for compliance to IFRS?
There is no fixed format prescribed for reporting of OBSC under IFRS. It should form part of notes to the quarterly and annual accounts. The amounts should not be discounted. The group accounting team may develop and prescribe a template in tabular format to capture all the information required for reporting in order to comply different paragraphs of IFRS (point no.2 supra). I tried to capture some points in a sample template as follows:
The amount to be reported under OBSC should be net balance commitment amount from contracts. The amount should be net of (1) advances paid against the agreement, (2) accrual/provisions accounted for and (3) expenses booked in books against the contract.
7. Transferring Off Balance Sheet items to On Balance Sheet transactions:
There are situations where we need to account for the Off Balance Sheet Commitments into our books of account to report it in Statement of Financial Position.
Take the case of implementation of the new IFRS-16 (leases). The standard requires that the lessee should account for all the Leases falling under the definition irrespective of classifying it under Operating Lease or Finance Lease. The standard (IFRS-16) has removed the distinction of Operating and Finance Lease for Lessees so that all the lease obligation (which were earlier reported as OBSC) are now to be shown in the Statement of Finance Position. The IFRS-16 requires that at the commencement of Lease the lessee recognises a Right to Use Asset and Lease Liability. The earlier classification of erstwhile standard (IAS17) relating to Operating and Finance Lease is now ceasing to exist for Lessee. Hence the reporting entity where ever applicable required to transfer earlier Off Balance Sheet Items to On Balance Sheet items in order to comply with IFRS-16 which effective date is 1st.Jan.2019. This was also one of the objective behind issuing IFRS-16.
During the applicability of IAS-17 the IASB had estimated that 85% of $3.3+ trillion of global leasing liabilities were being reported as Off Balance Sheet Items. Hence new standard IFRS-16 issued as a remedy. [Detail article can be referred at https://www.ifrs.org/news-and-events/2016/03/hans-hoogervorst-article-shining-the-light-on-leases/] [This article on Leases was published on IFAC Global Knowledge Gateway, 22 March 2016.By Hans Hoogervorst, IASB Chairman]
8. Relation between Contingent Liability[IAS37] and OBSC
The contingent liability is (a) a possible obligation that arises from past events and whose existence depends upon uncertain future events not wholly within the control of the entity; (b) a present obligation that arises from past events but not recognised because, it does not require settlement with economic resources or it cannot be measured reliably. As we have already discussed in point no.1 (supra), the OBSC refers to future obligation from current/existing contracts. So, the first point of distinction is the nature of obligation involved.
The contingent liability covers the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity, whereas OBSC refers to existing commitments which depicts future events within the control of the entity.
In some practical scenarios, for contingent liabilities we consider 50% probability of the obligation and if the percentage is high or closer to 100% than it is advisable to considerate as an expenses provision/accrual (liability). In case of OBSC the probability of obligation is 100% but we cannot treat it as a Liability since these are future obligations.
The above three paragraphs are showing dissimilarities between Contingent Liabilities (CL) and OBSC. But if we talk about the similarities between the two then it would be the recognition and disclosure requirement under IFRS. Both the items (CL and OBSC) should not be recognised in the Statement of Financial Position, but they should be disclosed in notes to account.
For example, (1) where the reporting entity expects to pay any damages to third party (say due to legal requirements) a contingent liability is disclosed, even if it unable to estimate the amount. (2) where the entity has given any firm commitment or guarantees then it can be termed as OBSC and disclosed.
9. Relation between Liability [Conceptual Framework 2010] and OBSC
Chapter 4 of the Conceptual Framework 2010 (IASB), Liabilities in a Statement of Financial Position represent the present obligation of the entity that arise from past events. Obligation is a duty or responsibility to act in certain way. Such obligation may arise due to a binding contract, statutory requirement, normal business practices and even business custom and desire. On the other hand, OBSC refers to future obligations/commitments.
For example, a mining company has entered into a contract of $12M for buying mining equipment (PPE) from an original equipment manufacturer in next accounting period. Based on the commercial terms negotiated the mining company has remitted an advance of $2M in the current accounting period. So as on the reporting date (say 31.Dec.20X8) the company has to report an OBSC of $10Million in order to comply with para74 IAS16 (PPE). In the next accounting period (say 20X9) after receipt of the mining equipment (PPE) the entity shall recognise and report a Liability of $10M until is paid to the vendor (the double entry impact will go to PPE/assets).
Lest take another example, A car manufacturing company provides a warranty with every car sold. This constitute a liability and would be recognised when the warranty is issued (on sale of car) than when claim is made. It is not an OBSC.
10. Relation between Provision [Conceptual Framework 2010 & IAS37] and OBSC
Provision or accrual is a Liability. It has all the characteristics of a Liability, but the amount of obligation is required to be estimated. The principles of IAS37 ensure that Provisions should be recognised with valid ground- (1) present obligation (legal or constructive), (2) outflow of economic resources will be required and (3) reliable estimate can be made. We account for Provisions for Opex and Capex transactions at each financial reporting period in compliance with IAS37.
For example, a mining company is obliged for environment cleaning or revegetation on closer of an opencast mine. In such a case we recognise Decommissioning Liability or Asset Retirement Obligation in our Financial Statement at the present value of future estimated obligations (legal or constructive). This is an example of Provision recognised as Liability. This is not an OBSC item.
11. Analysis of Off Balance Sheet Items for Investment Decisions as an Investor or Fund Manager
In securities market the Off Balance Sheet Items are regarded as Incognito Leverage since these are not appearing on the entity’s Balance Sheet even if they belong to the entity. The Off Balance Sheet obligations were regarded as part of the accounting fraud at Enron Corporation, Texas, US in 2001. [Report on New York Times on Nov.20,2001- https://www.nytimes.com/2001/11/20/business/in-new-filing-enron-reports-debt-squeeze.html ]
Off Balance Sheet items may create exclusion from of liabilities and associated assets from the Statement of Financial Position. It may understate assets and liabilities to effect on the financial ratios of the entity.
Hence off balance sheet items are always an important concern of investor at the time of assessing companies financial health. The current revisions in IFRS is always aimed at fewer and fewer off balance sheet item. Take the example of new IFRS-16 Leases which is effective from 1st Jan 2019, which introduces single lease accounting to bring Operating Leases on balance sheet [detail described in point no.7 supra].
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