The Annual Report (2/2)
In this lesson, you’re expected to learn:
– the main components of liabilities on a balance sheet
– the different types of leases
– invoice discounting, taxation, and shareholders’ equity
Now that we’ve seen the main components of the assets on a balance sheet, let’s take a look at the various liabilities.
A balance itself sheet only has two lines for liabilities:
• Current Liabilities: those due to be paid in the next 12 months.
• Long-term Liabilities: all others
Accounting for trade creditors is straightforward and exactly the same as what we saw last week.
Social Security and Other Taxes
Companies with employees have to pay national insurance and income tax on the wages and salaries which they pay those employees.
These charges are normally paid two to three weeks after the end of each month so they usually show up as a liability on any balance sheet. VAT is also included under this category.
They are any costs that need to be included in the accounts to satisfy our matching concept, but where no invoice has been received or where the invoice is dated after the year-end.
Deferred Revenue / Income (Cash in Advance)
Many companies can justify charging their customers in advance of delivering the goods. This is often just a deposit but in other cases, it could be a full payment for something.
Bank overdrafts are current accounts with a negative amount of cash in them. Many companies have such accounts from which they pay all their day-to-day bills and into which they put the cash they receive from customers. Banks usually grant an overdraft facility to companies (and individuals) which means that a company can run up an overdraft to a specified limit.
Normally there is no time limit on overdraft facilities but the banks nearly always retain the right to demand immediate repayment (repayment on demand). This is why they are treated as current rather than long-term liabilities.
Similar to personal loans, they are made to enable specific purchases of equipment, buildings and other assets to be made. Terms for repayment of the principal (the amount of the loan) and payments of interest are agreed in advance. The principal payments may be fixed amounts but usually they will be variable.
A loan agreement may have other conditions or restrictions, which are known as covenants. Provided the borrower does not breach the covenants, the bank does not have the right to demand immediate repayment.
A bank loan is nearly always accompanied by a charge or lienover the assets of the company. A charge guarantees the bank that, if the company gets into financial difficulty, the bank can have first claim over the proceeds from selling assets which are included in the charge.
If the bank has a charge over a specific asset, the charge is known as a fixed charge or mortgage. If the bank’s charge is over other assets of the company, such as stock or debtors, where the actual assets change from day to day as the company trades, it is known as a floating charge. Charges are generally known as security or collateral.
The owner of the asset is known as the lessor and the user is the lessee.
For accounting purposes, leases are divided into two sorts: operating leases and finance leases.
An operating lease is one in which the lessee pays the lessor a rental for using the asset for a period of time that is normally substantially less than the useful life of the asset. The lessor retains most of the risks and rewards of owning the asset.
For example, a company renting office space from a landlord for five years – the payments are typically made monthly or quarterly.
A finance lease is one where the lessee uses the asset for the vast majority of the asset’s useful life. In such circumstances, the lessee has most of the risks and rewards of ownership.
A typical example would be a car lease.
We account for finance leases in a different way from operating lease and the process is somewhat more complicated.
Instead of leasing it, you could obtain a loan from your bank and buy the car. If you did this, your balance sheet would show a fixed asset of €10,000 and a liability to the bank of €10,000. You would then depreciate the asset at an appropriate rate and pay interest on the loan, eventually repaying the loan at some point.
Having such a lease and treating it like an operating lease is known as off-balance sheet finance, because you are effectively getting a loan to buy an asset without showing either of them on your balance sheet.
As a result, companies can build up substantial liabilities without them appearing on their balance sheets.
Let’s go back to the car example.
Assume that you agree to pay the lessor €300 per month for 48 months to lease a €10,000 car.
You would be agreeing to pay a total of €14,400 to the lessor during the life of the lease. Effectively, the lessor has lent you €10,000 (the price of the car) which you have to repay in installments with interest of €4,400 over the 48-month time period.
Instead of getting a loan or an overdraft from a bank, you go to an invoice discounting house. It lends you money that is a proportion of your trade debtors.
When you receive the money from the customer, you immediately have to pay whatever amount was lent against that invoice back to the invoice discounter. As soon as you issue a new sales invoice, you tell the invoice discounter and it lends you money against the invoice.
However, it can be quite an expensive way to borrow money because as well as paying interest on the money lent to you, you also have to pay fees for the service.
What is a corporation tax?
A company makes sales and incurs expenses in doing so. After paying interest on any loans, the company makes a profit which is due to shareholders. The tax authorities take a share of that profit by taxing it. This is corporation tax.
Large companies have to pay corporation tax in installments during their financial year, while smaller companies pay it after the end of the company’s financial year.
Share CapitalThere are various types of share capital that a company can have.
• Ordinary shares: the most common type.
• Authorized number of shares: the maximum number of shares a company is allowed to issue.
When investors pay money into the company, shares are allotted to them i.e. shares are issued. Ordinary shares all have a par or nominal value – this is the lowest value at which the shares can be allotted.
Though shares cannot be allotted for less than the par value, they can be and frequently are, allotted for more than par value. The amount over and above par value that is paid for a share is called the share premium.
The total profit that the company has made throughout its existence that has not been paid out to shareholders as dividends.