Michael

In previous episodes of the Learning Finance series, We’ve learned Basics of Balance Sheet, different types of assets, how to use Balance Sheet to understand how companies work, and the basic rules of asset pricing system. We’ve also learned different types of liabilities, the four components of the Shareholder’s Equity, and what the balance sheet actually tells us, i.e. the information behind the terminologies and numbers.

In the balance sheet, we’ve already learned what our investment has become, and we can see if our initial investment’s value is guaranteed. But this is not enough – we want to know if we are making a profit.

That’s when the second financial statement comes in – Income Statement.

Within this process of money – things – money, the part that’s directly related to making money is when I sell my products. Once my products are sold, revenues are generated. Obviously, the revenue I receive comes at a price. When I sell a product, it no longer belongs to me; what I have lost here is the cost associated with acquiring the product. 

In addition, in order to run a company I will need to pay for all kinds of bills, bills to keep the lights on, etc. These are called expenses.

As you can see, knowing if my company is making a profit is not easy. That’s why I need a report – the Income Statement– to help me understand it. Now, let’s see what a Income Statement looks like.

An income statement starts with the revenue and ends with the net profit. In between you will find numerous costs and expenses. The top of the income statement describes money generated or spent from the company’s operating activities, i.e. its main business operations, and the bottom describes that from the company’s non-operating activities. After going over this post, you will be able to understand all of them.

Operating Activities

Cost of Goods Sold

The first line item is revenue. When I sell a product, I will get revenue associated with the selling of the product, but I also lose the ownership of the product, therefore the cost of goods sold.

A commonly heard concept is gross profit. But what is gross profit? Well, revenue minus cost of goods sold is gross profit.

Business tax and surcharges

Now let’s look at the next item — business tax and surcharges.

Generally speaking, there are several common corporation taxes, i.e. business tax, value-added tax (VAT), and income tax. Taxation is a complex topic individual to each country, so not everything you find here will apply to your home country. For example, not all countries have business tax and VAT, and some countries have additional types of taxes. However, you should get a basic feeling of what fits where after this.

Income tax should only apply when there is income, or profit. Therefore, it should appear only after total profits. When I subtract income tax from total profits, I will get my net profit.

Business tax and surcharges means if I am operating a business, regardless of whether I make a profit or not, I will need to pay for the tax and charges. Categorically speaking, these kinds of taxes are called turnover taxes.

Both business tax and value-added tax are turnover taxes.

However, you may have noticed that VAT is nowhere to be found on the Income Statement. That’s because VAT doesn’t belong here.

Now why is that? Why is business tax on the income statement, but VAT is not, considering that both are turnover taxes?

One major difference between business tax and VAT is that business tax is included in the price of product, but VAT is on top of the price of product.

Let’s see an example.

If I order food at a restaurant and pay 100USD for the dishes, the restaurant needs to pay business tax on that money. Let’s say the business tax rate comes at 5%. I will not pay 105USD because of the 5% business tax, meaning that the restaurant’s take-home revenue of my 100USD is 95USD.The business tax is included in the price, borne by the restaurant (seller).

In certain countries, you will encounter situations where you will see the extra tax amount on top of your standard meal prices. However, those taxes are NOT business taxes; they are a form of consumption tax. 

But VAT is different.

For example, if I go to buy a computer, there will be VAT incurred for this transaction. Before applying the VAT, the computer price might be 1,000USD. After applying the VAT, the price comes up to 1,170USD because of a 17% value-added tax. So if I only pay 1,000USD, the seller won’t give me the computer. I will have to pay 1,170USD so the transaction can come through.

For this transaction, who paid for the 170USD VAT?

The consumer.

The second major difference between business tax and VAT is that business tax is borne by the business, i.e. the seller, but VAT is borne by the customer, i.e. the buyer.

Now you should understand why VAT cannot be found on the Income Statement. 

Because the company pays for Business Tax, but consumers pay for Value-added Tax, the VAT on consumers shouldn’t be a company’s cost. That’s why we cannot find VAT on the Income Statement.

In practice, we as consumers don’t go to the tax bureaus every day to pay VAT on everything we’ve purchased. Instead, we give the VAT to the seller, and the seller will periodically pay the VAT withheld to the tax bureau. From the seller, i.e. the business’s perspective, that VAT should never be accounted for revenue. On the other hand, since the VAT belongs to the tax bureau, but just temporarily sits in the business’s bank account, it’s actually a liability owed by the business to the tax bureau.

For this reason, we actually can find VAT on the Balance Sheet, under the Liabilities section. It’s called tax payable.

After this tax item, we see three expense items: operating expenses, administration expenses and financial expenses. These three items are what we usually call period expenses.

Operating Expenses

What is operation?

For a manufacturing company, its operations are manufacturing and sales. So what are operating expenses?

Operating expenses are related to the company’s operations, i.e. advertisement costs, transportation expenses, warehouse fees, etc.

Expenses of different departments could fit in the operating expenses. For example, cost of promotions, salary of sales people, and various marketing expenses make up the operating expenses of sales departments. Another example would be company stores if the company has retail spaces. If the stores are leased, the rent paid out is operating cost. If the stores are owned by the company, the depreciation counts as operating cost as well.

Administration Expenses

Everything related to the management of the company is Administration Expenses. For example, the salaries of managers, administrative expenditures and depreciation on office building, etc., are all administration expenses.

One thing you might have already noticed is that different employee salaries are categorized as different types of expenses. For example, salaries of marketing and sales employees are operating expenses, but salaries of managers are administration expenses.

But what about wages of workers (in the context of a manufacturing company)? Where should this item fit in? Workers wages are direct manufacturing costs, so it should be put directly in costs of goods sold.

Depreciation of fixed assets should also be recorded in costs of goods sold, since fixed assets are directly used for producing the company’s goods. If the purpose of different fixed assets is different, the depreciation will go to a different category. For example, the depreciation of the stores is a sale expense, or operating expense, while that of an office building is an administration expenses.

Financial Expenses

Financial expenses are pretty straightforward; they are basically interests. Whether the interests you owe to the bank when you borrow, or the interests you earn from deposit savings from the bank. Since we are recording expenses, the former will be positive, i.e. money going out, and the latter will be negative, i.e. money coming in. In other words, when you are paying interests to banks, interest expenses are positive; when you are earning interests from banks, interest earnings are negative.

You may not always find three expenses in your Income Statement. In some countries, operating expenses and administration expenses may be combined as one item on the income statement. 

Recall that at the beginning we said that revenue minus costs of goods sold is equal to gross profit. Then we subtract the business tax and surcharges and the three expenses from gross profit, further closing in on our profit from operating the business. 

However, between financial expenses and operating profit, there are still three items left, which are impairment loss of asset, gains on changes in the fair value, and investment income.

Investment Income

For small companies that haven’t made any external investments, there will be minimal need to worry about investment income. But let’s say my company has a subsidiary company, and the latter gives me a dividend. This dividend is my income from investment. 

Investment is a special form of operating business, so we still consider it part as part of operating profit.

Impairment Loss of Asset/ Gains on Changes in the Fair Value

If you recall in assets valuation on the balance sheet, most assets are recorded with their historical costs, but financial investments and real estate investments are marked to market with their fair values. If the fair market value of any of the former two types of assets decreases, we will need to recognize the loss on the balance sheet. 

To make matters worse, it also affects the company’s profits on the income statement.

So far, we have subtracted the costs of goods sold from our revenue. We then paid the business tax and surcharges, as well as the operating, administrative, and financial expenses. After that we looked at our gain/loss from our investments and dividends generated from them. What’s left is our Operating Profit.

Non-operating Profit

The two items below Operating Profit are non-operating revenue and non-operating expenses. Let’s look at non-operating revenue first.

Non-operating Revenue

What is a non-operating revenue? The straightforward answer is any revenue generated from non-operating activities.

Let’s look at an example first.

A company checks its inventory and finds the actual inventory exceeds that on the books. This is called Excess Inventory. In this case, the excess inventory is a form of non-operating revenue.

Another example is when a company sells its fixed assets. 

We know that the goal of a business is to sell products to earn profits. Its fixed assets are required to produce products. However, there might be instances when the company decides to sell part of its fixed assets on an ad-hoc basis, and when it does, the sale will generate a large sum of money. This will also be recorded as a form of non-operating revenue.

Non-operating Expenses

We just talked about excess inventory as a form of non-operating revenue. Similarly, when we check our inventory but it turns out our inventory is less than what we’ve recorded on our balance sheet, we say there is a shortage on inventory, which is a form of non-operating expenses. 

Things like losses caused by accidents such as natural disasters, i.e. fire, flood, etc., are also non-operating expenses.

Why do we list Non-operating Revenues and Expenses separately?

Let’s look at what non-operating revenues and non-operating expenses have in common. They are both unrelated to the company’s operating activities. These activities happen by chance and don’t have continuity in the company’s plans.

What’s the benefit of listing non-operating revenues and expenses separately? Let’s look at this example.

Assuming that I have two companies. Both companies have a profit of 10 million dollars. For the first company, 9 million is operating profit and 1 million is non-operating profit. For the second company, 1 million is operating profit and 9 million is non-operating profit.

Which company would you like to invest?

For me, it is a no-brainer. I definitely will invest in the first company, even though both companies make the same amount of profit.

The reason is simple. I believe the first company will make at least the same amount of money the next year, but I highly doubt that the second company will manage to do the same.

Why?

Because the most profit the second company generates is from non-operating activities, i.e. projects that are not continuous.

This is the benefit of listing operating profit and non-operating profit separately. It not only tells you how much profit the company makes this year, but also provides information on whether the profit is dependable. In this way, we will be able to predict the company’s future profitability based on this year’s income statement.

Subsidies and Exchange Gain and Loss

In some countries, companies might be able to receive government subsidies for participating in certain economic activities as a way to boost investment in certain industries. These subsidies are also a kind of non-operating revenue. However, they should be listed separately, and we call it subsidies. Subsidies should also be recorded in the non-operating profit and loss section.

Some companies might operate in multiple countries, so they might receive payment in one currency but pay suppliers in another. However, currency exchange rates change every day, and when they do, my profits may suffer a loss or post a gain. This is called exchange gain (or loss). Exchange gain (or loss) should also go in the non-operating profit and loss section.

Getting Close to Our Actual Profit!

Total Profit

By subtracting our non-operating expenses and adding our non-operating revenues onto the operating profit, we have arrived at our Total Profit. Remember: subsidies and exchange gains or losses should also be taken account in the non-operating profit.

Net Profit

Now we’ve come to the final part. We have made some profit from the operations of the business, and have paid out our non-operating losses. After that, we still have quite some (total) profits.

Now there is still one thing left: income tax.

Depending on your country and industry, etc., business income taxes can range from 15% to 25%, or even more. For example, China has a business income tax of 25%, but can go as low as 15% for tech companies.

At this point, most people like me would assume that 75% of the total profit will be our net profit. 

However, this is not the case. Let’s look at our Income Statement again.

Apparently, the net profit(380) is less than 75% of the total profit(609 times 75%=456.75). In other words, the company paid more taxes. But why?

To understand this, we first need to know where the 25% business income tax has been applied. Should it be applied to the Total Profit?

The answer is no. Actually the company will need to pay 25% of its taxable income to the tax bureau as its income tax.

Unlike total profit, which is calculated based on the accounting standards, taxable income is calculated based on the tax law. That is why our total profit is different from our taxable income. Here’s an example.

Let’s say our company buys some advertisement, which is a form of operating expenses. According to accounting standard, we should be able to record the ad costs on the Income Statement, regardless of how much we’ve spent. However, the tax law actually stipulates that if a company’s advertising costs exceed a certain percentage of revenue, the exceeding portion cannot be deducted from its taxes.

If we assume that this percentage cap is 2% and our company’s revenue is 100 million, our tax-deductible portion will be 2 million. However, we actually spent 20 million on advertising. So even though all 20 million should be recorded as operating expenses, we actually will have to pay income tax on 18 million of those advertising costs. The taxable income now exceeds total profit by 18 million.

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This is what the income statement is all about. So what kinds of information does an income statement tell us from an economic perspective? We will go over it in our next post.

In previous episodes of the Learning Finance series, We’ve learned Basics of Balance Sheet , different types of assets , how to use Balance Sheet to understand how companies work, and the basic rules of asset pricing system. We’ve also learned different types of liabilities, and the four components of the Shareholder’s Equity. Now we will look at what the balance sheet actually tells us, the information behind the terminologies and numbers.

Understanding Assets

Let’s start from the left side of the balance sheet – Assets.

Before we ask the question “how much have I made?”, we want to make sure that the money I put into the company in the first place is safe. In other words, I want to know what the invested money has turned into.

This is what the left side of the Balance Sheet – Assets – tells us. Instead of just a pile of cash lying in the bank, some has become accounts receivable, some raw materials, finished goods , or product in progress, some factory plants, cars, computers, and office buildings, some rights of the land, patents and proprietary technology. And some are still lying in the bank in the form of cash. Essentially the Assets on the Balance Sheet tells us what our originally invested money has been used for.

Understanding Liabilities and Shareholders’ Equity

What does the right side – Liabilities and Shareholder’s Equity – tells us?

The right side tells us where your money comes from. While I might come up with a certain amount of money out of my personal pocket, I might also borrow money from the bank as loans. On top of that, I might also owe money to suppliers, customers, employees, or the Tax Bureau, etc.

Assets = Liabilities + Shareholders’ Equity

Obviously, the money raised (the right side of Balance Sheet) must be equal to the money spent (the left side of Balance Sheet). I cannot spend money I don’t have; or put it in another way, if I want to spend money I don’t have, I will have to borrow it from somebody else, thus owing them debts, and I cannot create assets out of thin air.

Assets equal Liabilities plus Shareholders’ equity is the most basic logic on the Balance Sheet, and it is also the most basic in accounting.

If you see a company’s statements do not conform to this relationship, the only possible explanation is that the statements are wrong. The equation must be obeyed at all times.

The formula that assets equal liabilities plus equity can be easily restructured into two equations:

1. By moving liabilities to the left, the equation becomes liability equal to the assets minus equity
2. By moving equity to the left, the equation becomes equity equal to assets minus liabilities

From a mathematical point, both restructured equations are correct. But from an economic aspect, only one is correct. Which one do you think it is?

Well only the second – shareholders’ equity = assets – liabilities – is correct. Why is that?

Let’s look at the first. 

The first equation means that after we allow shareholders to take back the money invested from assets, the remaining amount belongs to the bank. The owner of the company becomes the bank, which is not true.

On the other hand, the second equation means that after the company pays all the debts we owe to the bank and the rest of creditors, the remaining assets belong to shareholders. The shareholders own the company.

In other words, the shareholders own what’s left after the company repays all of the liabilities. This is called residual claims.

What if the company runs well and its assets actually have appreciated over time (great news!)? 

Well the bank will not ask you to repay more than your debt for your profitable business, since the debt to the bank is fixed. Therefore, the shareholders own the asset appreciation. 

But if the company is running poorly, and its assets actually become devalued over time, the bank will not grant you to repay less debt. Then you might run into a financial crisis. My debt to the bank is always fixed, so the asset depreciation has to be borne by me – the shareholder.

Then what is the ultimate goal for a company? A company should be making money for shareholders.

Recall that at the beginning, I’ve established that before I ask if I’ve made any money from the company, I want to know if my investment, i.e. my principal, is still safe, or what it has become. The balance sheet helps me answer that question. It gives me a breakdown of all items that my money has become, and has put a dollar amount behind each item. The asset items are the resources I have in running the company. 

If the balance sheet tells me that the total asset is worth 100 dollars, does it mean that the company has 100 dollars worth of assets now? In the past year, i.e. having this 100 dollars at all times over the past 12 months? 

Of course, the first explanation is correct. That is, the company has 100 dollars worth of assets at this particular moment. It’s like I’m taking a photo of the resources of the company, documenting what it has right now, without bothering whether it will change into in the future. Neither do I care what it looks like before the picture is taken.

Assets vs. Physical Properties

Asset and physical property are two different concepts. 

Here physical property means something tangible, i.e. physical things that I can touch. What could be an asset item that’s not a physical property? 

Let’s look at the Assets on the balance sheet.

Among all asset items, we see things such as accounts receivable, prepaid account, etc., that are just my rights. Even though I do own these rights to future claims, I cannot touch such a “right”, since it doesn’t have a physical form. Sometimes I don’t even have a certificate for them like a contract. However, we still say that this is an asset.

On the contrary, sometimes we do have physical properties in presence, but they are NOT our assets.

For example, I may rent someone else’s equipment. Even though I have the right to use it during that time, the equipment is not an asset item on my balance sheet. Another example would be the products I sell as a commissioned agent. Even though these products are stored in my company’s warehouse, they are not my assets.

Relationship between Assets and Costs/ Expenses

If you recall, there is an item called deferred expenses on the Balance Sheet that we discussed previously. Deferred expenses are really assets, but they will partially get expended as time goes by. Same thing happens for fixed assets and long-term deferred expenses. They gradually wear out, and the wear and tear become depreciation. 

This depreciation is a kind of cost; put it in other words, assets today are costs tomorrow. They are the same thing in different times.

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Now we understand why we need a balance sheet; since our investment in the company has now become a variety of things, we want to know the value of my principal investment. And the Balance Sheet can help us do just that – it describes the financial position of our company at a particular point of time.

In previous episodes of the Learning Finance series, I’ve learned Basics of Balance Sheet , different types of assets, how to use Balance Sheet to understand how companies work, and the basic rules of asset pricing system . I’ve also learned different types of liabilities. Now we will look at the last section on the Balance Sheet – Shareholder’s Equity.

There are four items in Shareholder’s Equity: 

1. Capital Stock
2. Additional paid-in capital 
3. Surplus reserve
4. Retained earnings

Let’s go over these together.

There are mainly two ways shareholders can invest in a company. 

First, shareholders can inject money into the company as their investment. By doing so, the shareholder’s money will become the company’s money, and the shareholder will receive equity, i.e. proof of ownership in the company, in exchange. This is a form of external investment.

Second, when the company makes a profit in its operations, the profit is originally owned by the shareholder. However, the shareholder may decide not to take the profit home but instead keep it in the company. This is also a form of investment, but internal.

For the four items mentioned above, which ones are external, and which internal?

It’s difficult to know the answer just by their names without fully understand what they are, but you can still guess that capital stock might be a form of external investment, and retainied earning is a form of internal investment. If those are your answers, then you guessed them right.

But what about additional paid-in capital and surplus reserve?

Right now, let’s just take note of the answer that additional paid-in capital is external, and surplus reserve is internal. By the end of this article, you will be able to understand what they are, and why.

External Investments

When capital comes in, it’s recorded on the Balance Sheet separately under two lines of items in the Shareholder’s Equity Section, Capital Stock and Additional Paid-in Capital.

Why do we account them in two separate items?

Capital Stock (Share Capital, Paid-in Capital, Equity…)

This is arguably the most important item. At least I think that way. 

However, this item can get a little bit confusing, since you may not always see the name Capital Stock on a balance sheet. Different types of companies may use different names for essentially the same thing. 

For example, the concept of “stock” only exists in public companies, i.e. only when a company goes public will its stocks be created. So in public companies, you will see this item with the names like Capital Stock, Share Capital, etc. In private companies, or limited liability companies, the same item is called paid-in capital. However, no matter what names are used, the meaning is the same. 

In certain countries such as China, every company needs a registered capital required by law. That is, when you form a company, you have to inject money into the new entity. The amount of money that you inject is called registered capital. In China, the value of capital stock (or share capital, paid-in capital) must be equal to the registered capital. In other countries, such registered capital requirements is not necessary, so this item won’t necessarily equal registered capital. All money invested is considered original fund of the company.

However, you might be wondering this:

If the actual money invested is more than the registered capital, where does the extra money go on our Balance Sheet?

The answer is Additional paid-in capital.

Additional Paid-in Capital (Capital Reserve, Treasure Shares…)

There is one type of company that will always have additional paid-in capital on its balance sheet. That type of company is publicly traded company. Why?

We know that publicly listed companies issues shares to the public. For example, when it issues 100 million shares of stock at 20 dollars per share, how should we record this transaction?

By doing some simple math, we know that the company raised 2 billion dollars. Since the nominal value per share is one dollar, we will record 100 million dollars as Capital Stock. The rest 1.9 billion dollars will be kept in Additional Paid-in Capital, as known as Capital Reserve or Treasure Shares.

The above example described how a publicly traded company accumulates capital reserve. But how can private companies generate additional paid-in capital? Let’s look at this example.

Say I invested one million dollars to start a small company. After a few years, the business runs well, and someone is interested in investing in my company. After some due dilligence and negotiations, we finally reached a deal: I agreed to sell 50% of the company for five million dollars. In other words, we both agreed that the company is worth 10 million dollars now.

But the thing is that I invested one million dollars and my new partner will invest five million dollars. How can I document this investment on the Balance Sheet so the shares are split 50/50, not 5/6 for him and 1/6 for me?

The answer lies in additional paid-in capital.

Out of the five million dollars, one million will go in paid-in capital, matching my initial one million-dollar investment and boosting the total equity to two million. The other four million dollars will go into additional paid-in capital. Since ownership percentage is only calculated by paid-in capital, the company’s ownership is now split equally between the two of us. The other four million dollars in the additional paid-in capital are now owned by all shareholders of the company.

That means I now own two million dollars out of the four. The second this investor invested five million dollars in my company, two million dollars will evaporate instantaneously out of his pocket. Why did he do that?

When I started the company from my own one million dollars, the company was worth just that. But after so many years, I’ve built up the company to a higher level, far more valuable than what it was. From this perspective, the investor exchanged his two million for the 50% of the company income in the future.

Internal Investments

When a company makes a profit, the shareholders can choose to either distribute those profits to themselves or keep them in the company. If they choose to keep the profits in the company, those profits essentially become internal investments.

Surplus Reserve (only in certain countries)

Surplus reserve is profit that cannot be distributed by the law. In some countries such as China, the law stipulates that a company must retain some profit as surplus reserve in the company. In other words, if the company earns 10 million dollars this year, I must leave at least one million in the company as surplus reserve. 

Shareholders are free to distribute the remaining nine million dollars; for example, they may decide to distribute three million dollars to all shareholders, and leave six million dollars in the company.

Retained Earnings

Where should we put the remaining six million dollars? In the retained earnings.

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By far we have gained a more complete understanding about the balance sheet. We’ve already known the meaning and composition of assets, liabilities and shareholders’ equity respectively. Later we will look at how the balance sheet presents a complete picture of a company’s finance.

In previous episodes of the Learning Finance series, I’ve learned Basics of Balance Sheet, different types of assets, how to use Balance Sheet to understand how companies work, and the basic rules of asset pricing system. Now we are moving on to the right side of the Balance Sheet.

On the right side of the balance sheet there are two sections – liabilities and shareholder’s equity. Let’s get into liability first. 

Current vs. Non-current Liabilities

Similar to how assets are structured into current and non-current ones, liabilities are also structured the same way. Current liabilities are to be repaid within the next 12 months, and non-current liabilities beyond 12 months. Pretty easy to remember. 

Current Liabilities

Short-term Borrowing

Short-term borrowings are bank loans with a 12-month or less maturity. Bank loans beyond that will be considered as long-term debt or long-term loans payable. For our company in the Balance Sheet, it has over 1.2 billion dollars of short-term borrowings.

Accounts Payables

Whom will a business owe money to besides banks? 

Well when a business sells goods to a customer, the customer may not pay the business right away, i.e. owing money to the business. Thus, the business has accrued accounts receivable, i.e. the right to collect the agreed-upon amount of money at a later time, and meantime, the customer has accounts payable with the same amount, i.e. the obligation to pay the business the agreed-upon amount of money at a later time. For our company, it has 688 millions of accounts payables.

Other Payables

One example would be one of my friends has a temporary cash flow issue, so he borrowed a million dollars from me. What do we call this? To me the lender, it is other receivable; to him, it is other payable. For our company, it has 9 million dollars of other payables.

Deposits Received

Now let’s go back to the situation when we purchase raw materials from the supplier. The supplier may ask for an upfront deposit, or prepaid accounts. This advance to supplier grants me the right to receive delivery of goods, and all goods are rightfully my assets. This prepayment will also become the supplier’s obligation, or a liability. This particular liability item is called deposits received, or advances from customers. Our company doesn’t have any deposits received from its customers.

Other Liabilities

There are many other items in the liability category, which are put into one line of item called other liabilities. This item is actually a combination of a number of items, so we need to break it down. 

If you look at it carefully, you will find this item is not a small amount; it is over a billion dollars. What do you think might be included in there?

In other words, whom will the business owe money to besides the bank, the suppliers and the customers?

Well first, almost all businesses owe money to their employees, since most businesses pay wages in the next month after their employees have provided their services. Of course this liability will be paid off very soon, or else employees will soon become ex-employees. This salary owed to the employees is called accrued payroll.

All businesses also owe money to the tax bureau on a regular basis, for the reason that most businesses don’t prepay taxes. What they do instead is paying taxes in the next month. So when the accountants prepare financial statements at the end of each month, there are taxes owed to the tax bureau. This liability is called taxes payable.

As a matter of fact, almost every business has accrued payroll and taxes payable.

Non-current Liabilities

Long-term Loans Payable

We went through this item briefly when we were talking about short-term borrowing. Long-term loans payable are essentially bank loans beyond 12 months. Our company has over 1.3 billion dollars of long-term loans, more than its short-term borrowings.

Bond Payable

Bonds are debt products issued by the company, and not all companies can issue bonds. As you can see, our company has no bond payable.

Long-term Payable

Long-term payables are related to certain specific kind of transactions such as leases. 

Normally when we rent something, the ownership of the product is not transferred. But in accounting, there might be instances where we need to document leases in the Balance Sheet. 

Leases are divided into two categories – operating leases and financial leases. Only financial leases are long-term payables.

When a lease is relatively long, and involves a large amount of money, it is often treated as a financial lease. Otherwise it is an operating lease. If a lease is considered an operating lease, then we are renting something we don’t own, i.e. the ownership is NOT transferred. Operating leases are expenses paid out by the company, therefore they don’t show up on the balance sheet. 

Financial leases, on the other hand, are treated as if we are paying a loan for an asset. Therefore, it means that the ownership of the asset is transferred, and the rentals are portions of the loan. In fact, from the moment we sign the lease contract of that asset, all the future rental expenses will turn into liability, also known as long-term payable.