Question

The following is an excerpt from our textbook:

Not too long ago, a look at the liabilities side of the balance sheet of an international company like BERU AG, showed how international companies reported financial information. Here is how one liability was shown:

Anticipated losses arising from pending transactions

3,285,000 euros

Do you believe a liability should be reported for such transactions? Anticipated losses means the losses have not yet occurred. Pending transactions means that the condition that might cause the loss has also not occurred. So where is the liability? To whom does the company owe something? Where is the obligation?

German accounting rules at that time were permissive. They allowed companies to report liabilities for possible future events.

1. For this discussion board, I would like you to discuss the pros and cons of allowing companies to record estimated losses for transactions that have not finalized. Why would this be useful to potential investors? How could management potentially abuse this practice? Do you think the benefits outweigh the potential problems?

Answer 1

Of all the financial statements issued by companies, the balance sheet is one of the most effective tools in evaluating financial health at a specific point in time. Consider it a financial snapshot that can be used for forward or backward comparisons. The simplicity in its design makes it easy to view balances of the three major components with company assets on one side, and liabilities and owners' equity on the other side. Shareholders' equity is the net balance between total assets minus all liabilities and represents shareholders' claims to the company at any given time.

Assets are listed by their liquidity or how soon they could be converted into cash. Liabilities are sorted by how soon they are to be paid. Balance sheet critics point out its use of book values versus market values, which can under or over inflate. These variances are explained in reports like “statement of financial condition” and footnotes, so it's wise to dig beyond a simple balance sheet.

Liabilities

In general, a liability is an obligation between one party and another not yet completed or paid for. In the world of accounting, a financial liability is also an obligation but is more defined by previous business transactions, events, sales, exchange of assets or services, or anything that would provide economic benefit at a later date. Liabilities are usually considered short term (expected to be concluded in 12 months or less) or long term (12 months or greater). They are also known as current or non-current depending on the context. They can include a future service owed to others; short- or long-term borrowing from banks, individuals or other entities; or a previous transaction that has created an unsettled obligation. The most common liabilities are usually the largest like accounts payable and bonds payable. Most companies will have these two line items on their balance sheet, as they are part of ongoing current and long-term operations.

AT&T 2012 Balance Sheet

Assets		Liabilities
Current Assets		Current Liabilities
Cash And Cash Equivalents	$4,868,000	Accounts Payable	$28,301,000
Short Term Investments	-	Short/Current Long Term Debt	$3,486,000
Net Receivables	$13,693,000	Other Current Liabilities	-
Inventory	-
Other Current Assets	$4,145,000	Total Current Liabilities	$31,787,000
Total Current Assets	22,706,000	Long Term Debt	$66,358,000
		Other Liabilities	$52,984,000
Long Term Investments	$4,581,000	Deferred Long Term Liability Charges	$28,491,000
Property Plant and Equipment	$109,767,000	Minority Interest	$333,000
Goodwill	$69,773,000	Negative Goodwill	-
Intangible Assets	$58,775,000
Accumulated Amortization	-	Total Liabilities	$179,953,000
Other Assets	$6,713,000
Deferred Long Term Asset Charges	-	Stockholders' Equity
Total Assets	$272,315,000	Total Stockholders' Equity	$92,362,000

Current Liabilities

Using the AT&T (NYSE:T) balance sheet as of Dec. 31, 2012, current/short-term liabilities are segregated from long-term/non-current liabilities on the balance sheet. AT&T clearly defines its bank debt maturing in less than one year. For a company this size, this is often used as operating capital for day-to-day operations rather than funding larger items, which would be better suited using long-term debt. Like most assets, liabilities are carried at cost, not market value, and under GAAP rules can be listed in order of preference as long as they are categorized. The AT&T example has a relatively high debt level under current liabilities. With smaller companies, other line items like accounts payable (AP) and various future liabilities like payroll, taxes and ongoing expenses for an active company carry a higher proportion.

AP typically carries the largest balances, as they encompass the day-to-day operations. AP can include services, raw materials, office supplies or any other categories of products and services where no promissory note is issued. Since most companies do not pay for goods and services as they are acquired, AP is equivalent to a stack of bills waiting to be paid.

Examples of Common Current Liabilities

• Wages Payable: The total amount of accrued income employees have earned but not yet received. Since most companies pay their employees every two weeks, this liability changes often.
• Interest Payable: Companies, just like individuals, often use credit to purchase goods and services to finance over short time periods. This represents the interest on those short-term credit purchases to be paid.
• Dividends Payable: For companies that have issued stock to investors and pay a dividend, this represents the amount owed to shareholders after the dividend was declared. This period is around two weeks, so this liability usually pops up four times per year until the dividend is paid.

Current Liabilities Off the Beaten Path

• Unearned Revenues: This is a company's liability to deliver goods and/or services at a future date after being paid in advance. This amount will be reduced in the future with an offsetting entry once the product or service is delivered.
• Liabilities of Discontinued Operations: This is a unique liability that most people glance over but should scrutinize more closely. Companies are required to account for the financial impact of an operation, division, entity, etc. that is currently being held for sale or has been recently sold. This also includes the financial impact of a product line that is or has recently been shut down. Since most companies do not report line items for individual entities or products, this entry points out the implications in aggregate. As there are estimates used in some of the calculations, this can carry significant weight. A good example is a large technology company that has released what it considered to be a world-changing product line, only to see it flop when it hit the market. All the R&D, marketing and product release costs need to be accounted for under this section.

Non-Current Liabilities

Considering the name, it’s quite obvious that any liability that is not current falls under non-current liabilities expected to be paid in 12 months or more. Referring again to the AT&T example, there are more items than your garden variety company that may list one or two items. Long-term debt, also known as bonds payable, is usually the largest liability and at the top of the list. Companies of all sizes finance part of their ongoing long-term operations by issuing bonds that are essentially loans to each party that purchases the bonds. This line item is in constant flux as bonds are issued, mature or are called back by the issuer.

Examples of Common Non-Current Liabilities

• Warranty Liability: Some liabilities are not as exact as AP and have to be estimated. It’s the estimated amount of time and money that may be spent repairing products upon the agreement of a warranty. This is a common liability in the automotive industry, as most cars have long-term warranties that can be costly.
• Lawsuit Payable: This is another liability that is estimated and requires more scrutiny. If a lawsuit is considered probable and predictable, an estimated cost of all court, attorney and settled fees will be recorded. These are common line items for pharmaceutical and medical manufacturers.

Non-Current Liabilities Off the Beaten Path

• Deferred Credits: This is a broad category that may be recorded as current or non-current depending on the specifics of the transactions. These credits are basically revenue collected prior to it being earned and recorded on the income statement. It may include customer advances, deferred revenue or a transaction where credits are owed but not yet considered revenue. Once the revenue is no longer deferred, this item is reduced by the amount earned and becomes part of the company's revenue stream.
• Post-Employment Benefits: These are benefits an employee or family members may receive upon his/her retirement, which are carried as a long-term liability as it accrues. In the AT&T example, this constitutes one-half of the total non-current total second only to long-term debt. With rapidly rising health care and deferred compensation, this liability is not to be overlooked.
• Unamortized Investment Tax Credits (UITC): This represents the net between an asset's historical cost and the amount that has already been depreciated. The unamortized portion is a liability, but it is only a rough estimate of the asset’s fair market value. For an analyst, this provides some details of how aggressive or conservative a company is with its depreciation methods.

Conclusion

The balance sheet, liabilities in particular, is often evaluated last as investors focus so much attention on top-line growth like sales revenue. While sales may be the most important feature of a rapidly growing startup technology company, all companies eventually grow into living, breathing complex entities. Balance sheet critics point out that it is only a snapshot in time, and most items are recorded at cost and not market value. But setting those issues aside, a goldmine of information can be uncovered in the balance sheet.

While relative and absolute liabilities vary greatly between companies and industries, they can make or break a company just as easily as a missed earnings report or bad press. As an experienced or new analyst, liabilities tell a deep story of how a company finances, plans and accounts for money it will need to pay at a future date. Many ratios are pulled from line items of liabilities to assess a company's health at specific points in time.

While accounts payable and bonds payable make up the lion’s share of the balance sheet's liability side, the not-so-common or lesser-known items should be reviewed in depth. For example, the estimated value of warranties payable for an automotive company with a history of making poor-quality cars could be largely over or under valued. Discontinued operations could reveal a new product line a company has staked its reputation on, which is failing to meet expectations and may cause large losses down the road. The devil is in the details, and liabilities can reveal hidden gems or landmines. It just takes some time to dig for them.

The question, “What is a liability?” is not easy to answer. For example, is preferred stock a liability or an ownership claim? The first reaction is to say that preferred stock is in fact an ownership claim, and companies should report it as part of stockholders’ equity. In fact, preferred stock has many elements of debt as well.1 The issuer (and in some cases the holder) often has the right to call the stock within a specific period of time—making it similar to a repayment of principal. The dividend on the preferred stock is in many cases almost guaranteed (the cumulative provision)—making it look like interest. As a result, preferred stock is but one of many financial instruments that are difficult to classify.2 To help resolve some of these controversies, the FASB, as part of its conceptual framework, defined liabilities as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.”3 In other words, a liability has three essential characteristics: 1. It is a present obligation that entails settlement by probable future transfer or use of cash, goods, or services. 2. It is an unavoidable obligation. 3. The transaction or other event creating the obligation has already occurred. Because liabilities involve future disbursements of assets or services, one of their most important features is the date on which they are payable. A company must satisfy currently maturing obligations in the ordinary course of business to continue operating. Liabilities with a more distant due date do not, as a rule, represent a claim on the company’s current resources. They are therefore in a slightly different category. This feature gives rise to the basic division of liabilities into (1) current liabilities and (2) long-term debt.

The operating cycle is the period of time elapsing between the acquisition of goods and services involved in the manufacturing process and the final cash realization resulting from sales and subsequent collections. Industries that manufacture products requiring an aging process, and certain capital-intensive industries, have an operating cycle of considerably more than one year. On the other hand, most retail and service establishments have several operating cycles within a year. Here are some typical current liabilities: 1. Accounts payable. 6. Customer advances and deposits. 2. Notes payable. 7. Unearned revenues. 3. Current maturities of long-term debt. 8. Sales taxes payable. 4. Short-term obligations expected to be 9. Income taxes payable. refi nanced. 10. Employee-related liabilities. 5. Dividends payable. Accounts Payable Accounts payable, or trade accounts payable, are balances owed to others for goods, supplies, or services purchased on open account. Accounts payable arise because of the time lag between the receipt of services or acquisition of title to assets and the payment for them. The terms of the sale (e.g., 2/10, n/30 or 1/10, E.O.M.) usually state this period of extended credit, commonly 30 to 60 days. Most companies record liabilities for purchases of goods upon receipt of the goods. If title has passed to the purchaser before receipt of the goods, the company should record the transaction at the time of title passage. A company must pay special attention to transactions occurring near the end of one accounting period and at the beginning of the next. It needs to ascertain that the record of goods received (the inventory) agrees with the liability (accounts payable), and that it records both in the proper period. Measuring the amount of an account payable poses no particular difficulty. The invoice received from the creditor specifies the due date and the exact outlay in money that is necessary to settle the account. The only calculation that may be necessary concerns the amount of cash discount. See Chapter 8 for illustrations of entries related to accounts payable and purchase discounts. Notes Payable Notes payable are written promises to pay a certain sum of money on a specified future date. They may arise from purchases, financing, or other transactions. Some industries require notes (often referred to as trade notes payable) as part of the sales/purchases transaction in lieu of the normal extension of open account credit. Notes payable to banks or loan companies generally arise from cash loans. Companies classify notes as short-term or long-term, depending on the payment due date. Notes may also be interestbearing or zero-interest-bearing.