Balance Sheet Liabilities
Balance sheet liabilities are obligations the company has to other parties. They are classified as current liabilities (settled in less than 12 months) and non-current liabilities (settled in more than 12 months).
#1 Balance Sheet Liabilities – Current
Accounts payable is the most common of all current balance sheet liabilities. This account represents payments that are owed to suppliers, contractors, and other parties that the company has purchased goods or services from. The purchase of inventory with credit terms is a common example of generating accounts payable balances.
Accrued expenses are those expenses that the company has “accounted for” by recognizing them as an expense, but has not yet been invoiced for. Once the expenses are invoiced, they move up into accounts payable.
Unearned revenue is a balance sheet liability that represents cash received for revenue that has not yet been earned. Since the company has not yet completed delivering the good or service, it has not recognized it as revenue yet. In the case where a client prepays for the good/service, the company has to record it as a liability called unearned revenue or deferred revenue.
#2 Balance Sheet Liabilities – Non-Current
Debt vs. Equity
When a company raises capital, they do so by issuing debt or equity. The difference between debt and equity is that debt carries an obligation to pay, but with equity there is no obligation:
- When a company issues stock, there is no obligation to pay out money on a fixed schedule. All payments (dividends) are discretionary.
- A bank loan is an example of debt. There is a contractual obligation to repay the loan (interest).
Preference shares and redeemable securities
Preferred shares are instruments with both debt and equity features. With preferred shares, dividends are not discretionary and are paid on a fixed schedule. Accounting treatment dictates whether preferred shares are placed in debt or equity on the balance sheet. Under IFRS, redeemable securities are noted as debt, while under US GAAP they are noted as equity.
The use of IFRS and US GAAP may affect a company’s financial presentation. If a company heavily uses redeemable securities, their treatment as either debt or equity will impact many ratios and performance metrics.
Convertible debt allows investors to convert their debt holdings into equity holdings.
Effective interest rate
The effective interest rate is the percentage of an original cash loan that an issuer will charge for giving a corporation a loan. Thinking in the opposite direction, the effective interest rate is the discount rate that discounts all future flows to a zero net present value.
The following example illustrates the use of the effective interest rate:
A company borrows €100,000 on January 1 from a bank. The bank agrees that the interest can be rolled up into the loan and repaid on December 31, four years later, along with the principal loan amount. The total repayment on that day will be €120,000.
How does the company reflect this arrangement in its financial statements over the 4-year term of the loan?
January 1 accounting
The company would reflect an increase in cash of €100,000 and an increase in liabilities of €100,000.
The ongoing accounting would be determined by the effective interest rate:
FV = PV(1+r)^n
120,000 = 100,000 (1+r)^4
1.2 = (1+r)^4
4√1.2 = 1+r
1.047 = 1+r
r = 4.7%
The company is incurring interest at 4.7%, but only paying it at the end of the loan. The annual accounting entries for the 4-year period will come from the following table.
The balance sheet liability grows from €100,000 to €120,000 over the 4-year period, with corresponding entries as interest expense each year.
Net debt is comprised of debt less the sum of all cash and cash equivalents.
- Net debt is used to compute enterprise values:
Enterprise value = Equity value + Net debt + Minority interest – JVs & associates
- Net debt is used to compute capital employed:
Capital employed = Equity shareholders’ funds + Net debt + Minority interest – JVs & associates
- Net debt is used to compute equity value:
Equity value = Enterprise value – Minority interest – Net debt + JV’s & associates
Balance Sheet Liabilities – Leases
When a company lacks sufficient funds to buy an asset (or simply prefers to use less cash), it may be able to lease the asset.
Leases fall into either operating leases (held off the balance sheet) or finance/capital leases (held on the balance sheet).
Characteristics of a finance lease include:
- The lease transfers ownership of the asset to the lessee by the end of the lease term.
- The lease term is for the major part of the economic life of the asset even if the title is not transferred.
- The leased assets are of a specialized nature such that only the lessee can use them without major modifications being made.
The line between an operating lease and finance lease is often a matter of judgment.
Operating lease accounting
Operating leases are expensed on the income statement on a straight-line basis over the lease term and are entered as operating cash flows in the cash flow statement. Companies must disclose operating lease expenses and future expenses in their financial statements. This is useful for bankers in capitalizing operating leases.
Finance lease accounting
Accounting for an asset under a finance lease is similar to when the company borrows money to buy the use of the asset. A depreciating asset and an amortizing liability are recognized on the balance sheet.
When leasing an asset, it is recognized on the balance sheet at the present value of the future lease payments, usually measured at the company’s incremental borrowing cost. The asset depreciates straight line over the term of the lease. The liability increases over time as interest accumulates but decreases with the lease payments, not only paying off the notional interest but also paying off some of the capital. This continues for the duration of the lease until the outstanding obligation has reduced to nil.
Lease payments are not expenses on the income statement. Instead, operating profit is reduced because of the depreciation expense and profit before tax is reduced further because of the interest expense.
Cash flow statement
Lease payments are treated as part repayment of interest and part repayment of capital.
A company enters into a 7-year lease to acquire the use of an asset. The interest rate implicit in the lease is 81⁄2% (approximately). The present value of the minimum lease payments is $614m. At the end of the first year of the lease, the financial statements would show:
Operating lease conversions
Company comparison is affected by differing accounting treatments of operating lease agreements. The two approaches used to reduce the differences in treatment are the discounted cash flow approach and the multiples approach.
New accounting rules published by IFRS dictate that operating lease conversion treatments will be eliminated by January 2019 and will instead be treated as financing leases. Therefore, these conversions will not be covered in this article. More information about IFRS 16 can be found here.
Balance Sheet Liabilities – Provisions
Provisions are either:
- A decrease in an asset, such as a provision against a receivable, believing it is not fully recoverable; or
- An increase in a liability, such as litigation where there may be a payout in the future
In either case, there is an issue of uncertainty. Here, we focus on provisions for liabilities.
Definition and recognition
Provisions for liabilities represent future uncertain cash outflows. The accounting treatment of provisions for liabilities depends on the likelihood of these future outflows:
- Probable: Recognize a provision
- Possible: No provision recognized. However, the existence of a “contingent liability” would need to be disclosed
- Remote: No accounting or disclosures required
When a provision is recognized, a liability and expense are created. When the payment is made, there is a decrease in cash and a corresponding decrease in liabilities. If the provision does not exactly match the cash outflow, then there will be a gain or loss recognized in the income statement, representing the difference between the two. Under IFRS, provisions are measured by discounting future cash flows. Under US GAAP, provisions are not discounted.
Common types of provision
The common types of provisions include:
Decommissioning provisions are an environmental provision with special accounting rules. The provisions recognize the cost of taking heavy infrastructure assets such as power stations and oil platforms out of service at the end of their lives. Due to lengthy timeframes, the time value of money of these provisions is often material and is required to settle the obligation. When discounting is used, the carrying amount of the provision increases in each period to reflect the passage of time, representing a borrowing cost.
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