Learning MBA Master Degree

TEACHER: Hello, Student. It is now time to describe the equities side of the balance sheet -liabilities and owners' equity. Do you recall the meaning of this phrase?

STUDENT: Liabilities and owners' equity represent the sources of the funds which have been used in acquiring the items on the asset side of the balance sheet.

TEACHER: Correct. The process of identifying the needs for new funds and acquiring these funds is part of the function known as "financial management." The treasurer and other executives who are responsible for financial affairs in a company need a considerable store of technical knowledge regarding the various means of raising money, the legal and tax rules relating to financing, and so on.

STUDENT: I assume that other members of management should have some understanding of these matters, right?

TEACHER: It is very desirable, indeed.

Nature Of Liabilities

A liability was defined as an obligation to an outside party. This definition is approximately correct; however, some legal obligations to outside parties are not liabilities in the accounting meaning of this word, and some accounting liabilities are not legally enforceable obligations.

As an example of an obligation that is not a liability, consider the case of an employee who has a written contract guaranteeing him employment at a stated salary for a number of years (e.g., professional athletes, coaches, executives). Such a contract is a legally enforceable claim against the business, but it is not a liability in the accounting sense, because according to generally accepted accounting principles this transaction is not recorded in the accounts until the person actually performs the work.

STUDENT: Yes, I know that many top executives have this type of contracts, especially since the taking over of companies by raiders became common. They are popularly known as "golden parachutes".

TEACHER: Yes. And we can also mention as an example that the amount of interest on notes and bonds that is to accrue subsequent to the date of the balance sheet is not recorder as a liability.

There also cases when a liability is not a definite obligation at the time it is set up, like an estimated allowance for future costs under a warranty agreement. When a warranty agreement applies, the liability account is set up in the period in which the revenue is recognized, the offsetting debit being to an expense account such as Estimated Warranty Expense. Later on, when repairs or replacements under warranty are made, the liability account will be debited and other balance sheet accounts such as parts inventory will be credited.

Current Liabilities

1. Current liabilities are those economic obligations which are payable in the near future, usually within the next twelve months, or during the next operating cycle if it is longer than twelve months (as with a whiskey distiller). Most firms' balance sheets will reflect these current liabilities: accounts payable (amounts due to suppliers in payment of materials sold to the firm); notes payable (amounts due to banks or other short-term lenders).
2. Taxes payable (owed to local, state, or federal governments); accrued expenses (most commonly, wages payable); and deferred revenue (such as prepaid rent or other advance payments such as for magazine subscriptions

STUDENT: Is it true that current liabilities in many cases represent "free" sources of funds to the company?

TEACHER: In a way, but many times an interest charge is "hidden" in the price; if payment was "cash on delivery" very possibly a discount could be obtained. Financial management, in cooperation with Purchasing, involves constantly answering the following question: "What is cheaper, getting financing from a supplier or paying cash and borrowing in the market?

Deferred Income Taxes

Deferred Income Taxes are not the same thing as taxes payable. The latter is an obligation to pay a specific amount of taxes by a specified date. Deferred income taxes are simply postponed taxes, and do not have the same formal characteristics of most other liabilities, such as a specified payment date or schedule. However, like other liabilities, deferred income taxes are classified as current and noncurrent. For example, deferred taxes arising from the tax effects of uncollected accounts receivable are a current item, whereas deferred taxes arising from fixed asset depreciation timing differences are noncurrent.

Contingent Liabilities

A contingent liability exists when a current situation may result in a liability upon the occurrence of some future event, but the amount, if any, of the liability cannot reasonably be predicted as of the balance sheet date.

STUDENT: You said "current" situation. Do you mean we can not recognize as a contingent liability events that are just possibilities?

TEACHER: Right, they must be concrete situations. Examples of contingent liabilities are possible fines, or damages from pending litigation; possible assessments of additional taxes; possible payments from default on debts which the company has guaranteed, etc.

Long-Term Liabilities

The long-term debt instruments that a firm may employ to obtain capital include, among others, term loans, bonds, mortgage bonds, subordinated debentures, and convertible bonds. What these various instruments have in common is that the repayment obligation on the part of the corporation issuing the debt extends over a period of more than one year.

STUDENT: How are the frequently mentioned "bonds" distinguished from other items in the category?

TEACHER: A bond is simply a certificate promising to pay its holder a specified sum of money plus interest at a stated rate. Bonds may be issued to the general public through the intermediary of an investment banker, or they may be "privately placed" with an insurance company or other financial institution. If the bond is not secured by specific assets of the issuing corporation, it is also referred to as a debenture.

STUDENT: And what are "mortgage bonds"?

TEACHER: A mortgage bond is a bond secured by designated "pledged" assets of the corporation, usually fixed assets. Should the firm default on the mortgage, the pledged assets are sold to repay the mortgage. If the proceeds from the sale of the pledged assets are less than the amount of the mortgage, then the mortgage holder becomes a general creditor for the shortfall.

STUDENT: In financial newspapers you frequently read the words "subordinated" and "unsubordinated" debt. What do they mean?

TEACHER: "Subordinated" means that in liquidation the debt holders claims on the firm's assets would be settled only if the claims of all unsubordinated creditors were settled in full.

Subordinated debt holder's claims do, however, take precedence over those of preferred and common stockholders.

Convertible bond is one that may be converted at the option of the holder into a specified number of shares of the issuer's common stock.

Recording a Bond Issue

If the DebtOr Corporation issues 100 bonds, each with a par value (also called principal or face value) of $1,000, and if the corporation receives $1,000 for each of these bonds, the following entry would be made:

Cash 100,000

Bonds Payable 100,000

Frequently bonds are issued for less than their par value, that is, at a discount, or for more than their par value, at a premium. This happens when the prevailing interest rate at the time of issuance is different from the coupon rate, the rate printed on the bond (nominal interest rate).

Example: If the DebtOr bonds of the example carry an interest rate of 8% and the current market interest rate is 6%, they will be sold at a "premium", an amount higher than the par value of $1,000. Conversely if the current interest rate were 9%, the bonds would be sold at a discount.

The offering of a bond issue to the public is usually undertaken by an investment banking firm which charges a fee for this service. In addition to this fee, the corporation also incurs printing, legal, and accounting costs in connection with the bond issue. These bond issue costs are set up as a deferred charge, which is an asset, and the asset is amortized over the life of the issue.

Balance Sheet Presentation

Bonds payable are shown in the long-term liabilities section of the balance sheet until one year before they mature, when ordinarily they become current liabilities.

STUDENT: Frequently when a bond issue matures, it is nor repaid, but rather replaced by a new issue of long term bonds. How is this reflected in the balance sheet?

TEACHER: When a bond issue is to be refunded with a new long-term liability it is not shown as a current liability in the year of maturity since it will not require the use of current assets.

Some bond issues are retired (repaid) in installments (a portion each year); in these cases that portion to be retired within a year is shown in the current liabilities section.

Bond Interest

An accounting entry is made to record the periodic interest payments to bondholders .

Retirement of Bonds

Bonds may be retired (redeemed) in total, or they may be retired in installments over a period of years. In either case the retirement is recorded by a debit to Bonds Payable and a credit to Cash, or to a sinking fund which has been set up for this purpose. Bonds are sometimes retired at maturity out of a sinking fund which has been created in installments over the life of the issue to ensure sufficient funds are on hand at maturity to retire the bonds. Bond sinking funds may be controlled by the originating corporation, but they are usually controlled by a trustee, such as a bank. Prior to maturity, sinking funds are invested by the trustee so as to earn interest on the funds thus tied up. Sinking funds usually appear in the investment section of the assets side of the balance sheet.

Some bonds can be redeemed before their maturity dates. Such bonds are said to be callable and contain a schedule of call prices as part of the terms of the issue.

STUDENT: Why should a company be interested in redeeming a bond issue before the maturity date?

TEACHER: In periods when interest rates have declined, a company may consider it advantageous to refund (refinance) a bond issue, that is, to call the old issue and float a new one with a lower rate of interest.

STUDENT: I guess we have covered the liabilities part of the equities side of the balance sheet. When are we discussing the other portion, owners' equity?

TEACHER: Before discussing the other portion of the equities side of the balance sheet, owners' equity, the three principal legal forms of business ownership need to be described.

Forms Of Business Organization

STUDENT: And these forms are...?

TEACHER: The sole proprietorship, the partnership, and the corporation.

Sole Proprietorship

A sole proprietorship is a business entity owned by a single person Proprietorship is a simple form for the organization of a business: with the possible exception of necessary licenses or permits, all one does to form a proprietorship is to begin selling goods or one's services. The main disadvantage is the liability of the proprietor for the firm's business debts. In the event of the firm's failure, the creditors have claims not only against the assets of the proprietorship (an accounting entity), but also against the personal assets of the proprietor, such as his home and car. Some one-owner firms are incorporated to protect the owner's personal assets from business claims.

Partnership

A partnership is a business with essentially the same features as a proprietorship, except that it is owned by two or more persons, called the partners. Like a proprietorship, a partnership is a relatively simple and inexpensive kind of organization to form. In a partnership each partner is personally liable for all debts incurred by the business, so in the event of the firm's failure, each partner's personal assets are jeopardized. Also, each partner is responsible for the business actions of the other partners.

When the proprietorship's annual income is divided among the partners, each pays income tax on his share at his personal income tax rate, whether or not these profits are actually distributed to the partners in cash.

Corporations

The corporation is a legal entity with essentially perpetual existence. The state grants it a charter to operate. The corporation is an "artificial person" in the sense that it is taxed on its net income as an entity, and legal liability accrues to the corporation rather than to its owners as individuals.

Compared with a proprietorship or a partnership, the corporate form of organization has these disadvantages: there may be significant legal and other fees involved in its formation; the corporation is limited in its activities to those specifically granted in its charter; it is subject to numerous regulations and requirements, including reporting of financial information, etc.

Moreover, at the time of this writing its income is subject to double taxation in the US: the corporation's net income is taxed, and distributions of any of this income to shareholders in the form of dividends is taxed again, this time at the shareholder's personal income tax rate.

Several proposals have been made to eliminate this "double taxation", and the Bush Jr. administration is determined to do away with it. It is highly likely that when you read this, "double taxation" in the US does not exist anymore

STUDENT: And what about the famous "S Corporations"?

TEACHER: An exception to the double taxation system is a "Subchapter S" corporation. These are corporations with ten or fewer stockholders which, if certain conditions are met, pay no corporate income tax. Instead, as in a partnership, the owners are taxed on their respective shares taxable income at their personal tax rates. In addition to its limited liability and indefinite existence, a corporation has the advantage of being able to raise capital from a large number of investors through issuing bonds and stock. Moreover, a corporate shareholder can usually liquidate his ownership by selling his shares to someone else.

Accounting For Owners' Equity

Proprietorship and Partnership Equity

Not much more need be said about the owner's equity accounts in a single proprietorship than the comments already made in a previous Module. There may be a single account in which all entries affecting the owner’s equity are recorded, or a separate drawing (withdrawal) account may be set up to handle periodic withdrawals made by the owner. If a drawing account is used, it may either be closed into the capital account at the end of the accounting' period, or it may be kept separate so as to show the owner's original contribution of capital separate from the effect on his equity of subsequent events. As far as the ultimate effect is concerned, it is immaterial whether the owner regards his withdrawals as salary or as a return of profit; but if he wishes to compare his income statement with that of a corporation, he will undoubted1v treat a certain part of his withdrawals as salary (although in a corporation that is managed by its owners, the distribution between salary and dividends may also be quite fuzzy in practice). Whatever the partnership arrangement, the law does not regard salaries or interest payments to the partners as being different from any other type of withdrawal, since the partnership is not an entity legally separate from the individual partners.

Ownership in a Corporation

Ownership in a corporation is evidenced by a stock certificate. This capital stock may be either common or preferred. Because a corporation's owners bold stock certificates which indicate their shares of ownership, owners' equity in a corporation is often called shareholders' equity or stockholders' equity. The balance sheet amount for shareholders' equity consists of two parts: the amount invested in the firm by its shareholders, called contributed capital; and retained earnings. The amount of contributed capital, in turn, is the sum of two amounts: the par or stated value of the outstanding shares of capital stock; and the amount the shareholders have invested in the firm by paying more for their shares than this par or stated value. I warn you that "par" value of outstanding common shares has a negligible (if any) significance.

STUDENT: Could you please tell me the difference preferred and common stock?

TEACHER: Very well.

Preferred stock pays a stated dividend, much like the interest payment on bonds. Preferred stock has preference, or priority, over common as to the receipt of dividends, as to assets in the event of liquidation, or as to other specified matters. Preferred stock may be cumulative or noncumulative. With cumulative preferred, if the corporation is unable to pay the regular dividend, the unpaid dividends add up or accumulate and are paid when the firm resumes payment of preferred dividends.

Common stock may be either par value or no-par value. Par value stock appears in the accounts at a fixed amount per share (often $1, $10, or $100), which is specified in the corporation's charter or bylaws. Whereas par value on a bond or on preferred stock has meaning, on common stock this figure is arbitrary, essentially meaningless, and hence potentially misleading. Except by coincidence, the par value of the stock in a going concern has no relation either to the stock's market value or to its book value.

To illustrate the issuance of stock, let us consider the issuance of 20,000 shares of $10 par value common stock. If 1,000 shares of this stock are issued at par ($10) and immediately paid for, the following entry would be made:

Cash . . 10,000
Common Stock .... 10,000

Stock is almost always issued for more than its par or stated value; that is, it is issued at a premium. In such situations the Common Stock account still reflects the par or stated value, and the premium is shown separately, in an account variously called Paid-In Capital, Paid-In Surplus or "Capital Surplus". (The Financial Accounting Standards Board suggests the more descriptive but cumbersome title "capital contributed in excess of the par or stated value of shares").

If in the preceding example 1,000 shares of $10 common stock were issued at $12 a share, the following entry would be made:

Cash 12,000
Common Stock... 10,000

Treasury Stock

Treasury stock is a corporation's own stock that has been issued and subsequently reacquired by purchase. The firm may reacquire its shares for a number of reasons: to obtain shares which can be used in the future for acquisitions, bonus plans, exercise of stock options by employees, and conversion of convertible bonds or preferred stocks; to increase the earnings per share; or to improve the market price of the stock. Such treasury stock while held by the corporation has no voting, dividend, or other shareholder rights.

Surplus Reserves

In an attempt to explain to shareholders why they do not receive dividends that are equal to the amount shown "as retained earnings", a corporation may show on its balance sheet an appropriation, or reserve, as a separate item that is subtracted from retained earnings. None of these reserves represents money, or anything tangible; the assets of a business are reported on the assets side of the balance sheet, not in the shareholders' equity section. The accounting entry creating the reserve involves a debit to Retained Earnings and a credit to the reserve. This entry simply moves an amount from one owners' equity account to another. It does not affect any asset account, nor does the reserve represent anything more than a segregated portion of retained earnings. Because the use of the word "reserve" tends to be misleading to unsophisticated readers of financial statements, it is fortunate that such usage has almost disappeared.

Retained Earnings

The remaining item of owners equity is Retained Earnings. As pointed out in previous Modules, the amount of retained earnings represents the cumulative net income of the firm since its beginning, less the total dividends that have been paid to shareholders (or "drawings," in the case of unincorporated businesses). Stated slightly differently, retained earnings shows the amount of assets which have been financed by "plowing profits back into the business" rather than paying all of the company's net income out as dividends. The importance to owners (and others) of understanding in some detail why retained earnings have changed between two balance sheet dates as a result of the firm's operations is the essential underlying reason that the income statement is prepared.

Dividends

Dividends are ordinarily paid to shareholders in cash, but they sometimes are paid in other assets. Dividends are debited to retained earnings in the period in which they are declared, that is, voted, by the board of directors, even though payment is made at a later date. Some shareholders, in the mistaken belief that the amount reported as retained earnings is "their money," put pressure on the directors to authorize cash dividends equal to, or almost equal to, that amount.

STUDENT: Not a clever idea?

TEACHER: Not necessarily. Clearly, retained earnings are not money at all, and for any of a number of reasons, cash may not be available for dividend payments even though the balance sheet shows a large amount of retained earnings.

STUDENT: So the shareholders’ request my be realistic only if the company has a large amount of cash, like is the case with many "high tech" firms such as Intel and Microsoft.

TEACHER: Right. Sometimes shareholders may be quite satisfied with a stock dividend, which actually does not change their equity in the corporation, since it increases each shareholder's number of shares by the same percentage; in other words, the stock is "diluted".

STUDENT: My stockbroker tells me that although a stock dividend does not change either the corporation's earnings, assets or its shareholders' proportionate equity, it does increase the number of outstanding shares. While in theory, therefore, such a dividend should reduce the per-share market price of the stock, in practice stock dividends are so small-that the market price of the shares may remain substantially unchanged. Hence the stock dividend may have some value to the shareholder as a dividend.

To record a stock dividend the retained earnings account is debited with the fair value of the additional shares issued, with the credit being to the capital stock account.

TEACHER: What your stockbroker said may work, but it still is "voodoo economics"!

A very common "voodoo economics" procedure is the "stock split". A stock split-up also merely increases the number of shares of stock outstanding. It has no effect on shareholders' equity; its effect is solely to repackage the evidence of ownership in smaller units. Hence, no transfer is made from retained earnings to capital stock when a stock split is effected.

STUDENT: And what about the market price of the stock?

TEACHER: A stock split automatically reduces the market price of a share of stock, or logically should do so. Since shares are usually traded in "bundles" of 100, it is alleged that at a lower unit price the stock becomes more appealing to a wider number of investors. This incremental demand may resulting in a gain in market value of each share owner's total holdings of the stock.

STUDENT: And there are still people who think stock markets behave rationally!

TEACHER: Good observation; you only need to look at the history of stock bubbles and crashes to realize that this is not so.

Stock Options

"Derivative" stock option instruments. A stock option is the right to purchase shares of common stock at a stated price within a given time period. The options of many companies are traded on stock exchanges, just as are other corporate securities.

These types of stock options are part of the so called "derivative" class of financial instruments and are not issued by the corporations themselves, they are private contracts between third parties. If you purchase or sell an option for IBM shares at the NYSE, IBM is not involved in the transaction.

Stock options granted by a corporation to its employees. These are a completely different case. Many corporations grant options to purchase its shares to certain officers and employees, either to obtain widespread ownership among employees or as a form of compensation. These options are not traded and are not transferable. They can only be exercised by the beneficiaries or their heirs in certain circumstances. At the time of this writing, some companies such as Coca Cola, "expense" the stock options issued to their employee at the time they are granted, while others like Intel don’t. Obviously the effect of expensing options at the time of granting them reduces net income of the period.

The following quotation is from Forbes.com and appeared on February 4, 2003: "As the International Accounting Standards Board in London completes its set of accounting rules requiring expensing of options, expect the U.S. to follow along. All companies will probably have to expense options in 2004."

Earnings Per Share

In analyzing the financial statements of a corporation, investors pay particular attention to the ratio called "earnings per share." This is computed by dividing net income applicable to the common stock by the number of shares of common stock outstanding. And now, time for our short ...

Summary

Equities consist of current liabilities, other liabilities (primarily long-term debt), and owners' equity. Current liabilities are distinguished from other liabilities by their time horizon (one year or less). Liabilities are distinguished from owners' equity by their nature as obligations to outside parties. Collectively the equities represent the sources of the funds which are invested in the firm's assets.

In a corporation, shareholders' equity consists of two parts which should always he reported separately:

1. the contributed capital, which is the amount paid to the corporation by each class of shareholders, and which is further divided into (a) the par or stated value of stock, and (b) paid-in capital; and
2. retained earnings, representing the cumulative amount of net income that has not been paid out as dividends.

Bye now , Student!