Advantages of having off balance sheet entries
The use of off balance sheet entries in a company helps in the financing of new ventures of the firm. The company may be referred to as an off balance sheet company and is used for the transfer of risk a new business enterprise from the main to the separate organization. Hence, the parent organization can finance the new enterprise without reducing the existing shareholders value of adding a burden of debt to the parent company.
Separate companies may be created to carry out a business venture which is part of the parent’s main line of undertaking. For example, oil drilling companies can institute off balance sheet subsidiary companies that will play the part of financing oil discovery projects (Dye 2002). The parent company can sell shares directly to shareholders. However, the tax laws were intended to get funds for the project from investors who are interested in investing on the discovery projects rather than investing in the parent company.
The use of off balance sheet entities clearly indicates the transfer of risk from the shareholders of the parent company to other investors who are willing to take the business risk. It is evident that, the oil company will use off balance sheet entities to transfer the discovery risk from the business to be shared with other people. Disadvantages of using off balance sheet entities There are many problems that arise due to the use of off balance sheet entities in a company.
The assumptions that justify the use of off balance sheet entity led to problems in companies when egos get too big. Banks are experiencing liquidity crisis due to off balance sheet financing. There exist uncertainties over the problem debt and actual value. Companies may misuse off balance sheet entries by using such items for the purpose of boosting the financial results of the company than the genuine business purposes. Off balance sheet items may bring bad results of the firm when economic realities differ from the company’s expectations.
Many countries in the world have been facing problems due to off balance sheet finance. It is evident that, accounts of companies are no longer reliable. America experienced credit crunch while Europe and Asia were exposed to high risk mortgage backed securities (Bowman 1980, p. 242). Off balance sheet financing activities may lead to problems of property loosing value. It’s unattractive when the markets start punishing stock just because it has off balance sheet item.
Here it becomes difficult to read the company files and footnotes hence there is a problem to figure out the impact of off balance sheet items. Off balance sheet entities result to bad effects when economic reality differs significantly from the assumptions that were used to justify the off balance sheet entity. The occurrence of immense self image brings many problems. Self image can be the basis for the misuse of off balance sheet items. Full disclosure is necessary for companies to show clear investment of its resources.