4

The Balance Sheet: Liabilities and Owners’ Equity

Learning Objectives By the end of this chapter, you should be able to: • Distinguish between current and long-term liabilities. • Identify various types of liabilities. • Identify the various components of equity on the balance sheet.

INTRODUCTION

The assets of a company are financed by liabilities and owners’ equity. In other words, assets are acquired with funds generated via debts or with owners’ investment. Current liabilities provide some of the working capital necessary to run a business day to day. Long-term liabilities and owners’ equity provide the permanent base of asset financing. In the sections that follow, you will learn more about the specific accounts that are classified under liabilities and owners’ equity. Much of this chapter entails definitions of terms. Knowledge of these terms forms a foundation for analysis of a company’s financial structure; eventually, these terms will come in handy when performing financial analysis using ratios and other quantitative techniques.

LIABILITIES

Liabilities are obligations resulting from past transactions requiring payment by conveyance of assets or the rendering of future services. Liability amounts must be definite or reasonably estimated. Liabilities are usually classified under the following major subheadings:

• Current liabilities

• Long-term liabilities

Current Liabilities

Current liabilities are debts that will be satisfied within one year or within the operating cycle, whichever is longer. The source of payment of current liabilities usually is derived from current assets. A typical scenario is that goods or services are sold on credit, an accounts receivable is created, cash is collected from customers, and that cash is used to meet payments on the current liabilities. Some typical current liabilities include:

• Accounts payable

• Notes payable

• Current maturities of long-term debt

• Cash dividends

• Accrued liabilities

• Revenues collected in advance

• Taxes payable

• Income taxes payable

• Guarantee and warranty costs

• Deferred income taxes

Accounts Payable

Accounts payable are obligations that arise from the purchase of stock-in-trade items, supplies, or services on open account. These may also be called trade accounts payable in order to differentiate them from amounts payable to partners, officers, stockholders, employees, or affiliated companies, which should be shown separately on the balance sheet. Rarely is interest charged on accounts payable, and they are a more informal arrangement than a notes payable, the topic of the next section.

Notes Payable

A note payable is a written promise signed by the maker of the note to pay a certain sum of money, either on demand or at a future date. The negotiable instrument (the note) may or may not bear a rate of interest although most notes payables are evidenced by a promissory note that calls for interest. It may be a trade note to suppliers of stock-in-trade items or services, or a short-term loan note payable to financial institutions or other lenders. The advantage to the holder of a note is that it is a written formal contract.

Current Maturities of Long-Term Debt

The portion of bonds, notes payable, and other long-term debts that mature or are payable within the next fiscal year are reported as current liabilities, with the balance shown as long-term debt.

Cash Dividends Payable

Unpaid cash dividends that have been declared by the board of directors but not paid as of the financial statement date are called dividends payable. Dividends do not accrue; the liability materializes only upon declaration by the board of directors.

Accrued Liabilities

Also known as accrued expenses, these represent expenses, such as wages, interest on note obligations, property taxes, and rent that accrue (or accumulate) on a daily basis. As a result, the amount of the specific accrual must be determined as of the end of the accounting period and is listed in the liability section of the balance sheet. If the amount cannot be determined exactly, a reasonable estimate must be made when the financial statements are prepared. Not only is this estimate necessary for proper presentation of the liability, it also generates a charge to an expense account that must be recorded and used in arriving at an income figure to properly match expenses to revenues.

Unearned Revenue

Any revenues collected before a service is actually performed must be shown as liabilities. This type of liability is often called revenues collected in advance. When the revenue becomes earned (as a result of performing a service or delivering a product), the unearned revenue account is reduced.

Taxes Payable

Sales taxes and employer portions of payroll taxes, such as social security, income taxes withheld, and other payroll deductions, are examples of taxes collected that will be remitted to a third party—such as a state department of revenue and the IRS—sometime in the future. Income taxes payable, which is a liability that results from the company’s earnings, are shown in a different account, called income taxes payable.

Income Taxes Payable

Corporations are income-tax-paying entities. As the accounting period progresses, a provision for estimated income taxes is made and the expense is accrued. The balance in the income taxes payable account represents these accruals, less payments made to the IRS. The IRS requires that corporations pay estimated taxes at various times during the year.

Due to the differences between taxable income as computed under tax laws and accounting income computed under generally accepted accounting principles, there arises the potential for differences between the reported income on the financial statements and taxable income on the tax return. These interperiod income tax allocations are reported on the income statement as deferred income taxes payable as well as in the notes to the financial statements.

Guarantee and Warranty Costs

A warranty is a commitment by a seller to make good on deficiencies in a product. It entails future costs that could be material but are indefinite in terms of amount, payee, or due date. (The costs of guarantees and warranties should, however, be recognized if they can be reasonably estimated.)

These charges represent an estimate of all costs expected to result from products sold with warranties and guarantees, and are recognized in accordance with the matching principle.

There are two methods of recording these costs. The first is the cash basis, in which warranties are charged to current operations as incurred. The cash method is not an acceptable method under generally accepted accounting principles. The second is the accrual method, where an estimated amount is charged to current operations. For example, a company may sell 500 units and estimate that each unit will incur $100 in warranty costs. The company would charge an expense account for $50,000 and record a liability for $50,000. This liability is usually current, unless there are long-term, extended warranties.

Long-Term Liabilities

A debt that takes the company longer than one year to satisfy is classified in the balance sheet as a long-term liability. If the time period of a long-term liability is reduced to one year or less, the debt should then be moved into the current liability section. Since most long-term debts carry an interest obligation, the interest accumulation should be shown as a current liability.

Debts are sometimes payable in installments. When the year begins, the amount to be paid during the ensuing year should be moved from the long-term to the current liability section. Examples are mortgages, bonds, debentures, and notes payable with maturity dates later than one year.

Long-term debt is often used as a permanent source of funds for financing growth, since the cost (interest) of long-term debt is usually fixed. The use of long-term debt can leverage earnings, which means that the fixed cost of long-term debt can mean that greater earnings in high-revenue years can be achieved than could be realized with variable-cost financing. In addition, the interest paid on long-term debt is tax deductible as a business expense; therefore, the real cost of long-term-debt financing is less than the cost of equity financing (dividends), which is not tax deductible.

Long-term debt may be subject to various restrictions or covenants. Since these may include working capital ratios, debt levels, dividend restrictions, etc., the financial statement user should review the notes to the financial statements to determine whether there are covenants that may affect the ability of the company to repay other obligations. Two popular types of long-term liabilities—mortgage payable and bonds payable—are detailed in the sections that follow.

Mortgage Payable

A mortgage payable comes into existence when real property is pledged as security for a loan. The mortgage creates a lien on the property to secure payment so that should the borrower default, the pledged assets can be sold by the lender, and the proceeds from the foreclosure sale used to satisfy the debt. If the pledged asset’s value is less than the total amount of the mortgage obligation, the mortgage holder becomes a general creditor for the difference.

Bonds Payable

Bonds payable are long-term promissory contracts, called indentures, that promise to pay a specific amount of money at a specified time as well as to pay periodic interest on the outstanding principal. The following are descriptions of several types of bonds.

Debenture Bonds. This is an obligation protected not by collateral or tangible assets, but only by the general credit rating of the issuer. There may be requirements included to protect the buyer. Requirements for such protective measures may include maintenance of a specified working capital ratio, immediate maturity of the issue in case of default in interest payments, and restrictions on dividends to stockholders.

Guaranteed Bonds. A bond is guaranteed if the payment of principal and interest is guaranteed by a person or company other than the issuer.

Income Bonds. With income bonds, the payment of interest income depends on the issuing company’s earnings. If earnings are sufficient, the interest payments will be made. If the earnings are not sufficient, interest payments may be skipped or deferred to a future date. If the interest payments are deferred to a future date, the income bond is called cumulative. If the bond interest is cumulative, interest that cannot be paid in one period will be carried forward as a lien against future income.

Corporate bonds may be classified in more detail than income bonds according to such factors as the way the bonds are registered, pay interest, make payments, or mature.

Registered Bonds. These bonds are issued in the name of the owner. When a registered bond is sold, the seller must surrender the certificate. A new certificate is issued to the buyer. Periodically, the bondholders of record will receive interest checks.

Bearer Bonds. Also known as coupon bonds, these bonds are not recorded in the name of the owner; ownership may be transferred by delivery without endorsement of the bond showing the transfer of ownership by a former owner. Interest coupons are attached to the bond. Periodic interest is paid by presenting the appropriate coupon at a bank. Bearer bonds eliminate the need for recording changes in ownership and preparation and mailing of the interest checks. However, since they are not registered, the bondholder does not have the protection that registered bonds offer.

Term Bonds. These bonds are an issue that has the same maturity date.

Serial Bonds. These bonds are an issue that matures in installments.

Convertible Bonds. These bonds are convertible into another security, usually equity.

Deep Discount or Zero Coupon Bonds. These are issues that are sold at a discount and provide that all the interest is earned by paying the full face value at maturity.

Bonds should be presented on the balance sheet in a manner detailed enough for the reader to understand. Disclosure of only the face value of outstanding bonds is not sufficient. The preferred method is to give a description of the security, the interest rate it bears, and its maturity date. This information is usually presented in the footnotes.

OFF-BALANCE-SHEET FINANCING

Off-balance-sheet financing is a form of utilizing resources without showing the source of funding for those resources (which often is debt or equity). One common example of off-balance-sheet financing is operating leases. Generally accepted accounting principles in the United States have set numerous rules for companies to follow in determining whether a lease should be capitalized (included on the balance sheet) or expensed (and kept off the balance sheet). Significant forms of off-balance-sheet financing should be disclosed in the notes to the financial statements. The term “off-balance-sheet financing” came into use during the Enron bankruptcy.

OWNERS’ (OR SHAREHOLDERS’) EQUITY

Owners’ equity is defined as the amount of right or interest investors have in the assets of an enterprise after all liabilities owed to the company’s creditors are satisfied.

There is no guarantee, however, that the amounts shown under the owners’ equity section of the balance sheet will be received by the owners. A company that is a going concern may not liquidate its assets in the near future, and even if liquidation occurs, management may not be able to generate enough cash to pay off the liabilities and cover the owners’ investment.

Owners’ equity is usually divided into four parts:

1. Capital stock at the par or stated value

2. Additional paid-in capital or amounts paid over par

3. Retained earnings representing the undistributed earnings of the entity

4. Treasury stock

Capital Stock

Often, the ownership interest of a corporation is described in terms of capital stock. Owners of a corporation buy shares of capital stock; the stock certificates are evidence of ownership. Four basic rights are inherent in the ownership of stock. If only one class of stock exists, these rights are shared by the stockholders in proportion to the number of shares of stock they each own. These rights are:

1. The right to vote for corporate directors and thereby be represented in the company’s management

2. The right to share in the profits of the business by receipt of dividends declared by the directors

3. The right to share in the distribution of cash or other assets in the event of corporate liquidation

4. The preemptive right to purchase additional shares, in proportion to one’s present holdings, in the event that the corporation elects to increase the number of shares of outstanding capital stock

Additional Paid-In Capital

Paid-in surplus is capital paid in excess of par or contributed by stockholders or outsiders. In other words, it is the total in excess of the par, or stated value of the stock, and is separated from retained earnings and capital stock on the balance sheet. To illustrate the concept of additional paid-in capital, assume a sale was made of $100,000 of par value, common stock for $115,000. The $115,000 is debited to the cash account. However, because the stock had a par value of $100,000, only $100,000 would be added to the capital stock account. The excess ($15,000) of the capital received ($115,000) over the par value of the capital stock ($100,000) should be entered into an account called additional paid-in capital.

Retained Earnings

Retained earnings are the accumulated profits that have not been distributed to the shareholders through payment of dividends. A portion of the retained earnings can be earmarked for purposes other than dividend distribution. These are labeled restricted earnings. This appropriation reduces the amount of retained earnings that are free and available for dividends. When the need for the appropriation passes, the dollar amount set aside is returned to the regular account, again available for dividends. Appropriations should be disclosed clearly in the equity section of the statement and are often footnoted to provide full disclosure. Among the types of restricted earnings are appropriations for plant expansion and contingencies.

Treasury Stock

This is a corporation’s own stock that has been issued or reacquired. Treasury stock can be resold, but the purchase of treasury stock by the company creates a temporary reduction in paid-in capital. As shown in the example balance sheet in Exhibit 4–1, treasury stock is negative equity; the amount paid for the stock ($22,500 on the December 31, 20X2 balance sheet) must be deducted from stockholders’ equity. Shares of stock in the company’s treasury are not eligible for dividends, nor do they grant voting rights.

Treasury stock is never classified as an asset. It is contradictory to imply that a corporation can invest in itself, although treasury stock may be sold to obtain needed funds. Treasury stock is also used by corporations to award shares to employees under certain benefit plans such as stock bonuses or pension.

Exhibit 4–1 presents the liability and equity section of a company’s balance sheets.

Liabilities fall into one of two broad categories: current or long-term. Current liabilities are obligations that are to be satisfied or paid within one year, and the source of their payment is usually current assets. Long-term liabilities are obligations that mature in a future period beyond one year. Liabilities are one type of claim (claim by creditors) against the assets of a company. The owners also have a claim against the assets. This is called owners’ equity.

Owners’ equity is the book value of the owners’ interest in a company. Owners’ equity usually includes a number of components, including common and preferred stock and retained earnings. Common stock is the purest form of ownership in a corporation and entitles the holder to dividends when declared by the board of directors. Those dividends are paid from retained earnings and therefore are linked to both the corporation’s cash position and its profits. Preferred stock is also an ownership interest but its dividends are distinct from common stock dividends in that preferred stock gives the holder priority when dividends are paid. This means that if there is enough cash and profits to pay dividends, the preferred stockholders must receive their dividends first.

Sometimes a portion of retained earnings can be re-allocated to a separate restricted account. Such a move limits the amount of retained earnings that can be paid out of the balance of the main retained earnings account.

ANSWERS TO “THINK ABOUT IT...” QUESTIONS FROM THIS CHAPTER

1. 1. D, 2. A, 3. D, 4. A, 5. C

2. 1,000 × .05 × $25 = $1,250

3. A.	3
B.	2
C.	4
D	5
E.	1

4. A.	CL
B.	CL
C.	LTL
D.	CL
E.	LTL
F.	LTL
G.	CL

5. A.	20,000 × $45 = $900,000
B.	$40 × 20,000 = $800,000
C.	($45 − 40) × 20,000 = $100,000

6. A.	At $166,667 outstanding shares, EPS = $6.00; therefore, 33,333 shares need to be repurchased (200,000 − 166,667).
B.	33,333 shares × $10 = $333,330
C.	Equity of $2,110,000 prior to the treasury stock purchase, less the value of the treasury stock purchased, which is $333,330, equals equity of $1,776,670.