Liabilities

The liabilities are what a company owes, divided into current and long-term liabilities.

3.3.1.3.1 Current Liabilities. Current liabilities are debts that must be paid within a year from the date of the balance sheet. They are paid from the current assets. Current liabilities include accounts payable, notes payable, accrued expenses payable, and income taxes payable.

Accounts payable are such items as invoices for raw materials and supplies that a company has purchased from suppliers for which payment is usually due within 30, 60, or 90 days.

Notes payable include money owed to banks and other creditors. Promissory notes are in this category.

Accrued expenses payable are in addition to accounts payable. They may include such items as salaries, wages, interest on borrowed funds, insurance premiums, and pensions.

The liability known as income taxes payable is the debt due to various taxing authorities such as federal, state, and local governments. It is common practice to isolate this item from other expenses. These taxes are usually paid quarterly.

3.3.1.3.2 Total Current Liabilities. The sum of the accounts payable, notes payable, accrued expenses payable, and income taxes payable is called total current liabilities.

3.3.1.3.3 Long-term Liabilities. Long-term liabilities are debts due more than a year from the date of the financial report.

3.3.1.3.4 Bonds and Loans. First mortgage bonds are issued at a stated interest rate due in a stated year. They are backed by the company's property. Debenture bonds, on the other hand, are backed by the general credit of the company rather than by company property. Long-term loans from insurance companies and investment houses are another form of long-term liability.

3.3.1.3.5 Deferred Income Taxes. Deferred income taxes are encouraged by the government as a tax incentive that will benefit the economy. An example of such an incentive is accelerated depreciation, which provides rapid write-off in the early years of an investment. The net effect is to reduce what the company will pay in current taxes, but the full amount must be paid in the future. To smooth out wide fluctuations in a company's earnings, an entry is made for deferred taxes. This entry shows what the taxes would be without accelerated depreciation write-offs.

3.3.1.4 Total Liabilities

The sum of current and long-term liabilities constitutes total liabilities.

3.3.1.5 Stockholders'Equity

This is the total interest that the stockholders have in the business. The stockholders' equity is the net worth of the company, namely, total assets minus total liabilities. For convenience, stockholders' equity is divided into three categories: capital stock, capital surplus, and accumulated retained earnings.

3.3.1.5.1 Capital Stock. Capital stock is classified into broad groups: preferred stock and common stock.

The stockholders who have preferred stock have a preference over the shareholders regarding dividends and/or the distribution of assets. Some preferred stock is called cumulative which means that if in any given year the company does not pay dividends, the unpaid dividends accumulate, and when these obligations are paid, the preferred stockholders receive stock dividends before the holders of common stock. Preferred stockholders do not normally have a voice in company affairs or voting rights unless the company fails to pay them dividends. Preferred stock is carried on the company books at a stated par value.

On the other hand, there are no limitations on the dividends paid to holders of common stock. If the company's earnings are high, dividends are paid, but if the earnings are low, dividends may not be paid at all. Common stock is valued at stated par value.

3.3.1.5.2 Capital Surplus. Capital surplus is the amount of money stockholders paid for stock over and above the par value of the stock.

3.3.1.5.3 Accumulated Retained Earnings. This term is sometimes referred to as earned surplus. The accumulated retained earnings are calculated by subtracting the dividends paid to stockholders from the net profit. If all the profits in one year are not distributed, they are retained by the firm and added to next year's earnings. They may be used, for example, for research and development activities, and/or for the purchase of capital equipment.

3.3.1.6 Total Stockholders'Equity

The total stockholders' equity is the sum of the preferred stock, common stock, capital surplus, and accumulated retained earnings.

3.3.1.7 Total Liabilities and Stockholders' Equity

The sum of the total liabilities and the stockholders' equity is what the company owes. For the balance sheet to "balance," the sum must equal the total assets.

3.3.2 The Income Statement

The income statement is also known as the profit and loss statement, the earnings statement, or the statement of operations. It displays the financial operating activities of a firm for the year and may be an indication of the company's future performance. A typical statement will show figures for the current year as well as one or two previous years' activities. Frequently, an annual report will include a 5- or 10-year summary near the end of the report. The term "consolidated" may appear, indicating that all the financial activities of the company and its subsidiary operations are reported in a single statement (Table 3.9) [5].

3.3.2.1 Net Sales

The net sales is the amount of money received for the goods sold less the amount of returned goods and allowances for reduction in prices (e.g., allowing for freight on goods shipped).

3.3.2.2 Cost of Goods Sold and Operating Expenses

This item includes all the expenses in converting raw materials into finished products, including depreciation, as well as sales, administration, research, and engineering expenses.

3.3.2.2.1 Cost of Goods Sold. The cost of goods sold represents the cash operating expenses for raw materials, labor, utilities, supplies, supervision, maintenance, waste disposal, plant indirect expenses, and so on.

3.3.2.2.2 Depreciation, Amortization, and Depletion. The federal government allows a company to charge off a portion of an asset due to wear and tear as well as obsolescence each year as an operation expense. This is known as depreciation; it is a paper transaction and is not a cash item. Amortization is the decline in useful value of a tangible asset such as a patent. Depletion is the diminution of a natural resource, such as coal in a mine. All these paper allowances appear as one item in most income statements.

3.3.2.2.3 Sales Administration, Research, and Engineering Expenses (SARE). These are expenses associated with maintaining sales offices, paying the corporate officers and their staffs, as well as research and engineering expenses not attributable to a specific project.

3.3.2.3 Operating Profit (Operating Income)

This entry is the difference between net sales and all operating expenses.

3.3.2.3.1 Other Income. Other income may be derived from dividends or interest received by the company in other investments, patents and licenses, and additional sources.

3.3.2.3.2 Income Before the Provision for Federal Income Taxes. When other income is subtracted from operating profit, the result is the income before the provision for federal income taxes.

3.3.2.3.3 Federal Income Taxes. Every company has a basic tax rate that it must pay. Because of tax incentives, tax credits, depreciation write-offs, capital gains, and so on, the actual taxes paid may be less than the basic rate.

3.3.2.4 Net Profit for the Year After Income Taxes

This entry is obtained by subtracting the provision for federal income taxes from the income before provision for federal income taxes.

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