A good question came from a reader of my book this week. The question concerned the proper treatment of off balance sheet obligations relative to my evaluation process for scoring stocks. I’ll discuss this issue a bit today.

Off balance sheet obligations, by definition, are not listed on the balance sheet. Another term that refers to the same issue is off balance sheet financing. As I’ve shared before through blog posts, it’s important to check out the 10Q and 10K financial filings for information that offers further detail than that provided on the face of the financials (balance sheet, income statement, statement of cash flows). Off balance sheet obligations are required to be disclosed in the corporate financial filings.

Fortunately, many companies, especially smaller ones don’t have any off balance sheet items. Further, for those companies that do have such items (example that could result in an off balance sheet item would be an operating lease), there can also be an “off balance sheet asset” which would offset the obligation thereby leaving a zero effect on equity. Recall that equity is the remainder after deducting liabilities from assets.

My response to the questioner was to check the financial filings for off balance sheet items. Again, the net effect of their existence to the balance sheet equity, in many cases, will be zero suggesting that they are unimportant to my valuation approach. However, my valuation approach also utilizes the “composition” of the assets and liabilities to discern quality and low price.

Let me illustrate what I mean by a net effect on equity of zero but a change in asset/liability composition. Let’s say assets are $100,000 and liabilities are $30,000, then equity will be $70,000 (100,000 less 30,000 = 70,000). If we have an off balance sheet obligation of $10,000, then, including it would alter the liability number from $30,000 to $40,000. This would appear to reduce the equity by $10,000. Most often, though, there would be an offsetting asset (of equal amount) also missing from the balance sheet (if interested in reading further, go here for lease reporting and look specifically at the balance sheet effect of capital leases vs. operating leases). Thus, if these items were ON the balance sheet, assets would be $110,000 while liabilities would be $40,000, leaving equity still at $70,000. While equity is unchanged in my illustration, the composition of asset and liability accounts would be changed and, under my scoring technique, I’m looking at composition to discern both the quality of equity and a low price for it.

My personal practice is to “pencil in” the missing accounts to the balance sheet IF I decide to evaluate (for investing purposes) a company with off balance sheet items. Of course, you may be thinking “well, he has an extensive background in accounting and knows what to pencil in so it’s easy for him to say that.”

Here’s the good news. I have done this (penciling in) very rarely, though, because my tendency is simply to bypass companies with off balance sheet financing. While there are legitimate accounting reasons for items not being listed on the balance sheet, I can’t get the Enron reminder out of my head. Enron made a mockery of the balance sheet by how it hid debt from investors. So, I tend to move on to consider another company that has no off balance sheet items.

Also, I’ve occasionally overlooked off balance sheet items in the filings before and ended up purchasing the subject stock. My sense is that doing so has had minimal impact since the total amount of equity is often unchanged (as explained above) by the missing balance sheet items.

Going further with this issue is beyond the scope of a blog post. The SEC filings (10Q, 10K) will include a brief statement as to whether off balance sheet financing exists. Most often when I check the company filings, I find the statement that there are no off balance sheet items.

I hope you do not find this post overwhelming. While accounting can surely be technical, the good news is that off-balance sheet items are not the norm and even if you own a company where they exist, their net equity effect is often zero.