 Overview

Welcome to Week 4 of the course. Before we begin, let us go back to our balance sheet structure. A
balance sheet is a financial statement that reports a company's assets, liabilities, and shareholder
equity at a specific date, and is used to evaluate a business and calculate financial ratios. It provides a
snapshot of a company's finances (what it owns and owes) as of a certain date.

The balance sheet adheres to an equation that equates assets with the sum of liabilities and shareholder
equity:

Assets = Liabilities + Shareholders’ Equity

We have already considered the assets section of the balance sheet, this week we will be discussing
the second section of the balance sheet, which is liabilities and stockholders’ equity. These are the
sources of financing.

We will start with liabilities, which are the debts and obligations that a company owes to outside
parties. All liabilities will eventually mature, and when they become due, they must be settled, so they
have a maturity date. You should keep in mind that the persons or companies who provide the cash to
the company in the form of debt are creditors and not shareholders or owners:

Total Liabilities = Total Assets− Shareholders’ Equity

Next, we will consider owners’ equity, this is the section that reflects what the company owes to its
shareholders. It comprises the capital and retained earnings that were earned and retained by the
company. Take note that it does not have a maturity date:

Shareholders’ Equity = Total Assets−Total Liabilities

Note that in this week you will be introduced to an interview The Sherlock Holmes of Accounting:
Howard Schilit Explains the Mystery of His Art. It includes a video 'Financial Shenanigans: How
to Detect Accounting Gimmicks and Fraud in Financial Reports'. It is a lengthy video and you
will not be expected to view in one sitting. Make sure you set aside some time in each of the following
weeks to complete watching the whole video.

In the final week of the course you will be asked to record a short recorded commentary on aspects of
the video. Take the time now to review the graded assessment in week 8 to help support any notes you
may take as you watch the video.

I hope you have enjoyed the course so far and that you find this week challenging but rewarding.

 Learning Outcomes

By the end of this week you will be able to:

o evaluate current and long-term liabilities.

o understand and apply measurements for shareholder equity.
A liability is something that is owed by the company to another party. 

Liabilities are debts or obligations of a company that occurred from business transactions that
require disbursements of assets (cash), or provide services at a future date (unearned revenue). 

Liabilities are divided on the balance sheet into two categories: 

1) Current liabilities: Current liabilities relate to short-term payables to suppliers, employees,

banks, and others that need to be settled or cleared within one year (or an operating cycle). 
2) Long-term liabilities: Long-term liabilities relate to long-term notes, bonds, and deferred
income taxes that need to be settled after one year of the balance sheet date. 
In this lesson, we will consider the different types of liabilities.

Reporting Liabilities on the Balance Sheet - Economic Consequences

Consider the quote below and read over it carefully:
The reported values of liabilities affect important financial ratios that shareholders, investors,

creditors, and others use to assess management’s performance and a company’s financial condition.

Seven of Dun & Bradstreet’s 14 key business ratios, for example, directly include a measure of

liabilities: (1) quick ratio ([cash + short-term investments + receivables]/current liabilities), (2)

current ratio (current assets/current liabilities), (3) current liabilities/shareholders’ equity, (4) current

liabilities/inventory, (5) total liabilities/shareholders’ equity, (6) sales/net working capital, and (7)

accounts payable/sales. 

These ratios and others that include liability measures are used by interested outside parties to

determine credit ratings, assess solvency and future cash flows, predict bankruptcy, and, in general,

assess the financial health of an enterprise. In addition to using liability measures to evaluate the

future prospects of a firm, shareholders, investors, creditors, and managers are interested in liabilities

for other important reasons.

A particularly important example is debt financing, which can be very valuable to shareholders

because funds generated by borrowing can be used to generate returns that exceed the cost of the

debt. Because interest is tax deductible (reducing the cost of debt), this strategy (called leverage) is

very common. However, shareholders, managers and potential investors must pay close attention to

the amount of liabilities and the contracts that underlie them because debt increases the riskiness of

the company. Interest payments must be met before dividends can be distributed, and, in the event of
liquidation, outstanding payables must be satisfied before shareholders are paid. Many loan contracts,

for example, restrict the amount of dividends that can be paid in any one year to the common

shareholders. The Boeing Company, an aircraft manufacturer, operates under debt covenants that

include many restrictions, including the payment of dividends. As of December 31, 2019, Boeing

reported that it is in full compliance with these covenants.

Pratt, 2020. [1]

Current Liabilities and Important Financial Metrics

Let's remind ourselves of the common indicators of liquidity (the ability to pay debts in the near
future).

Working Capital = Current Assets − Current Liabilities

Current Ratio = Current Assets/Current Liabilities
Remind yourselves of the other ratios covered in the first three weeks. If you have not already
done so, note them down with a simple explanation as to their use and implications.

https://dish.gcs-web.com/financial-information/fundamentals/ratios

The Sherlock Holmes of Accounting:

Howard Schilit Explains the Mystery of
His Art
By Usman Hayat, CFA
Posted In: Financial Statement Analysis
Because of his track record in detecting the manipulation of financial
results, Howard Schilit has been called the Sherlock Holmes of accounting.
Whereas most forensic accountants come in after the fact for the investigation
and litigation, Schilit is the rare exception who comes in to detect accounting
manipulation before it is widely discovered.

Currently, Schilit works as the CEO of Schilit Forensics, a New York–based

forensic accounting consultancy, founded by him. Working for large
institutional investors, Schilit has not only made accounting interesting but
also made a highly profitable business out of it. Once an academic who taught
accounting, Schilit is the lead author of Financial Shenanigans: How to
Detect Accounting Gimmicks & Fraud in Financial Reports. To find out what
it is this modern-day Sherlock Holmes does and how exactly he does it, we
recently interviewed him. Here is an edited version of the interview.

CFA Institute: What is the difference between accounting fraud and

accounting manipulation?

Howard Schilit: The horrendous accounting fraud — what we saw in Enron,

Tyco, and WorldCom — is relatively rare. It breaks the law and violates
accounting standards. Accounting manipulation that I like to call accounting
shenanigans is different. It tends to be done within the letter of the law and
technical interpretations of accounting standards but present a misleading
picture of the economic performance of the company. Sadly, this is quite
common. I deal with accounting shenanigans. This is my world. There are no
smoking guns here. You have to find signs of companies camouflaging
problems. I pick up these signs by doing a behavioral analysis of the
management of the company.

Give us some examples of accounting manipulation.

Let me first clarify that in any example I give, I make no assertion that the
company concerned is doing anything illegal or willful to violate accounting
standards. I am just sharing my analysis without alleging wrongdoing. Let me
give you two examples.
First, a great example is a US company Equinix (EQIX). In the second quarter
of 2013, it announced that it was switching to a relatively conservative
accounting practice in recognizing part of its revenue — say, recognizing
revenue over four years instead of two years. But a few months later, it
announced that it would regard this switch as a correction of an error instead
of a change in estimate. This way, in the third quarter, the company changed
revenues for prior years going back to 2006, which enabled it to bring millions
of dollars of revenue to the current year that did not have to anything to do
with the current year.

A second example is a Japanese company, Ulvac (6728). Around 2011, it

reported its sales were down 1% and operating profit was up 38%. In the
aftermath of the tsunami and Fukushima disaster in Japan, this was a great
result. In reality, company sales were down 21% and instead of a profit there
was a large loss. The company switched to aggressive accounting, using
percentage of completion method for revenue recognition, picking up revenue
much earlier. Though it did disclose in a footnote that had it used the same
revenue recognition method as before, its sales would have been down 21%
and there would be a loss.

In your second example, because the company had made the

implication of the change in accounting practice known in a
footnote, did it still mislead anyone?

Yes, the company was still able to paint a rosier picture. I looked at all the sell-
side research reports on the company, and none had figured it out. The quality
of analysis was just not good enough. They probably overlooked the footnote.
Perhaps they could not cover the issue for other reasons, such as closeness to
the company’s management.

What has been the role of the external auditor in cases of

accounting manipulation?

In most cases, auditors give the opinion that they give. It is more or less the
same language everywhere, that in their view, the financial statements fairly
present the financial position of the company. “Present fairly” are the two key
words. In my view, in the examples I gave you, a well-thinking honest person
would not agree that this is fair presentation. I don’t want to make any
sweeping statement that the auditor is the problem. There is no reason to
assume that auditors are not good decent people trying very hard to do their
job well. What I think is that the auditor is not well trained to take into
account such issues from the perspective of the investors.

I can tell you that those who take the CFA exams are quizzed on these types of
shenanigans. I know that CFA Institute has been buying my book. I am almost
certain those writing questions for CFA exam have been making good use of
the contents of my book. In contrast, there is not a single question in the CPA
exams on these types of issues. Accountants have a different culture, they
learn the accounting rules and the tax rules and so on but they don’t learn how
to analyze things from the perspective of investors.

What do you think are the motivations of management of a

company manipulating its financial statements?

Just as I have a pretty benign evaluation of auditors as good decent people, I

don’t think business executives are crooks either. There is tremendous
pressure from the market on short term results. Picture yourself in the
position of a company’s management. Every three months, you have to
disclose the quarterly results to the market. If the results are not to Wall
Street’s liking, your stock could get crushed. See what recently happened to
the 3D Systems Corporation (DDD). It is down by something like 26% after its
quarterly results did not meet expectations. It’s a tough call: miss the number
or game the numbers. Sometimes, cooler heads prevail. At other times,
management can’t resist the temptation. If management has been boasting of
a long streak of growth, as it did in case of Equinix, they may find it hard to
announce that the streak has been broken. Companies have ups and downs for
no fault of the management, but CEOs are very competitive, very successful
people, who do not like to lose, who can’t declare defeat. A lot of it is hubris.
How do you find warning signs of potential accounting
manipulation?

What I do is really a behavioral analysis of the preparers of financial

statements, the management of a company. I love the kind of work Richard
Thaler does in behavioral finance, what investors are supposed to do and what
they end up doing. Its also about the kind of analysis that I do, but I do it for
the management rather than investors. I have to pick up signs of change in the
behavior of the management — what they highlight, what they don’t. Why
would they stop reporting something that they were voluntarily reporting
previously? You have to find out a change in accounting practice. Once you
have found it, the questions to ask are not “Is it legal?” and “Is it permissible?”
The questions to ask are “Why?” and “Why now?”

What are your views on the ability of short sellers to detect

accounting manipulation?

Over the years, I have worked with more than 500 investment managers. I can
tell you that if you are a short seller and you have the skill set to detect
accounting manipulation, you will probably have a very successful career. The
market may keep moving against you when it is focused on macro issues, such
as whether the US Federal Reserve is tightening the monetary policy or not.
But when market is focused on a company’s fundamentals, short sellers have
to win over other investors who can’t do such deep analysis.

What’s your advice to analysts who would also like to detect

accounting manipulation?

Have real deep training in accounting analysis. Have a strong understanding

of basics. Do things like the Intermediate Accounting sequence. Make use of
the books available out there. The granddaddy of my field is Abraham Briloff,
who also led me into this career. His books are still in print. Then there is my
book and there are books by Thornton O’Glove and Charles Mulford.
Technical training aside, just be a curious person, read carefully, ask good
questions, have a healthy dose of skepticism. Look for a change in accounting
practices by the management, and always ask these two questions: “Why?”
and “Why now?”

What are your thoughts on forensic accounting as a career for

young professionals?

The vast majority of people in forensic accounting, perhaps as much as 99%,

work on assignments after the fact, after something bad has already
happened. In these cases, forensic accountants support the two sides in
litigation. There is even a certification in this area. But that has got absolutely
nothing to do with my work. I am from the 1%, those who have to find the
train wreck before it has happened, before a company gets into trouble with its
auditors, before the SEC asks it to restate earnings. Investment managers hire
in-house staff for this type of analysis. Others also outsource is to firms like
ours. This is a phenomenal and a highly desirable specialty.

Liabilities Revisited
Let's consider again, exactly what are current liabilities?

 1

1Current liabilities are the company's short-term financial obligations that are due within
one year or a normal operating cycle.
2They are expected to require the use of current assets (or the creation of other current
liabilities) to settle the obligation.3
3Categories: (1) determinable (dollar amount known), and (2) contingent (involves an
estimate).
 4
4All current liabilities need to be reported on the balance sheet and at the balance sheet
date, and most importantly, no liability is omitted. Liabilities are more apt to be
understated than overstated!!

Estimated Liabilities
The liability is known to exist; the exact dollar amount cannot be finalized or verified until a
later date (warranty obligating).

Here are some common current liabilities including estimated liabilities:

1. Accounts payable. 
2. Unearned revenues.
3. Short-term notes payable.
 4. Other payables (accruals); salaries payable; rent payable; interest payable;
insurance payable; income taxes payable. 
5. Dividends payable.
6. Current maturities of long-term debts (within one year).
7. Contingent liabilities - lawsuits, warranties.

We will look at each in the pages that follow.

Accounts Payable
Accounts Payable
Accounts payable is a balance sheet item that is reflected under the current liabilities section.
Accounts payable are debts that are usually paid or cleared within one year.

Accounts payable categories are:

1. Trade accounts payable (commitments to suppliers for purchases of merchandise). 

2. Other accounts payable (liabilities for any goods and services other than merchandise).

What is Accounts Payable (AP) Turnover Ratio? 

The accounts payable turnover ratio is a key indicator of the company’s liquidity and how it is
managing cash flow.
The accounts payable turnover ratio measures how quickly a business makes payments to

creditors and suppliers that extend lines of credit. Accounting professionals quantify the

ratio by calculating the average number of times the company pays its AP balances

during a specified time period.

A high accounts payable ratio signals that a company is paying its creditors
and suppliers quickly, while a low ratio suggests the business is slower in
paying its bills. This is a critical metric to track because if a company’s
accounts payable turnover ratio declines from one accounting period to
another, it could signal trouble and result in lower lines of credit.

Conversely, funders and creditors seeing a steady or rising AP ratio may

increase the company’s line of credit.
What Is Accounts Payable (AP) Turnover
Ratio?
The accounts payable turnover ratio measures how quickly a business makes
payments to creditors and suppliers that extend lines of credit. Accounting
professionals quantify the ratio by calculating the average number of times the
company pays its AP balances during a specified time period. On a
company’s balance sheet, the accounts payable turnover ratio is a key
indicator of its liquidity and how it is managing cash flow.

Key Takeaways on Accounts Payable (AP)

Turnover Ratio
 A higher accounts payable ratio indicates that a company pays its bills
in a shorter amount of time than those with a lower ratio.
 Low AP ratios could signal that a company is struggling to pay its bills,
but that is not always the case. It could be using its cash strategically.
 Businesses that rely on lines of credit typically benefit from a higher
ratio because suppliers and lenders use this metric to gauge the risk
they are taking.

How to Calculate Accounts Payable (AP)

Turnover Ratio
Accounting professionals calculate accounts payable turnover ratios by
dividing a business’ total purchases by its average accounts payable balance
during the same period.
Accounts Payable (AP) Turnover Ratio
Formula & Calculation
Accounts payable turnover rates are typically calculated by measuring the
average number of days that an amount due to a creditor remains unpaid.
Dividing that average number by 365 yields the accounts payable turnover
ratio.

Average number of days / 365 = Accounts Payable Turnover Ratio

Breaking Accounts Payable Turnover into Days

Use this formula to convert AP payable turnover to days.

Accounts Payable Turnover Ratio in Days = 365 / Payable turnover ratio

How can you analyse your accounts payable turnover ratio?

To see how your company is trending, compare your AP turnover ratio to
previous accounting periods. To see how attractive you will be to funders,
match your AP ratio to peers in your industry.

What is a good accounts payable turnover ratio?

Generally, a high AP ratio indicates that you satisfy your accounts payable
obligations more quickly.

Do you want a higher or lower accounts payable turnover?

It depends. If your business relies on maintaining a line of credit, lenders will
provide more favourable terms with a higher ratio. But if the ratio is too high,
some analysts might question whether your company is using its cash flow in
the most strategic manner for business growth.
Accounts Payable (AR) Turnover Ratio
Example
Say that in a one-year time period, your company has made $25 million in
purchases and finishes the year with an open accounts payable balance of $4
million.

$25 million / $4 million = 6.25

That means the company has paid its average accounts payable balance 6.25
times during that time period.

Increasing Accounts Payable Turnover Ratio

Creditors and investors will look at the accounts payable turnover ratio on a
company’s balance sheet to determine whether the business is in good
standing with its creditors and suppliers. Higher figures indicate that a
company pays its bills on a more timely basis, and thereby has less debt on
the books.

While that might please those stakeholders, there is a counterargument that

some businesses may be better off deploying that cash elsewhere, with an
eye toward growth.

Decreasing Accounts Payable Turnover Ratio

Lower accounts payable turnover ratios could signal to investors and creditors
that the business may not have performed as well during a given timeframe,
based on comparable periods.
Tracking Payables Turnover Ratio
While businesses may have strategic reasons for maintaining lower accounts
payables turnover ratios than cash on hand would show is necessary, there
are other variables. Companies could have low turnover ratios due to
favourable credit terms. Similarly, they might have higher ratios because
suppliers demanded payment upon delivery of goods or services. Some
companies may spend more during peak seasons, and likewise may have
higher influxes of cash at certain times of the year.

AP Turnover vs. AR Turnover Ratios

Accounts payable turnover provides a picture of a company’s
creditworthiness, while accounts receivable turnover ratios measure how
effective is at collecting revenues owed to it. A high accounts receivable
turnover ratio indicates a company is effectively collecting what it’s owed,
whereas a low ratio signals a company is struggling in its collection process or
is extending credit to the wrong customers.

Tracking Your Accounts Payable Turnover

Businesses can track their accounts payable turnover ratios during each
accounting period without having to gather additional information. Using the
abovementioned formulas, here is an example of how to calculate your
accounts payable turnover ratio. Simply take the sum of your net AP during a
given accounting period and divide it by the average AP for that period.

Net AP / Average AP = Accounts Payable Turnover Ratio

In order to determine the amounts that you need to divide:

 Net AP: Subtract all credits (such as inventory returned to suppliers)

from gross AP incurred.
 Average AP: Add your AP balances at the beginning and end of the
accounting period and divide the sum by 2.
Example:

During FY 2020, a company’s total AP for funds owed to creditors and

suppliers was $1 million. However, the company received credits for
adjustments and returned inventory amounting to $100,000. After subtracting
the $100,000 in credits from the $1 million in gross AP, the net AP equals
$900,000.

The company had a total AP balance of $80,000 in Jan 1, 2020 and ends the
year on Dec. 31, 2019 with outstanding AP of $120,000. Taking the $200,000
total, dividing it by 2 gives an average AP of $100,000. After dividing the net
AP of $900,000 by $100,000, the company’s accounts payable turnover ratio
was 9.0.

Net AP: $1,000,000 -$100,000 = $900,000

/
Average AP: $80,000 + $120,000 = $200,000 / 2

= Accounts Payable Turnover Ratio: 9.0

Importance of Your Accounts Payable

Turnover Ratio
Executive management should pay close attention to the company’s accounts
payable turnover ratio. Investors and any suppliers poised to extend credit will
look at it closely. It can have an impact on cost of goods sold, as suppliers
may use that ratio to determine financing terms—and that can affect the
bottom line.
Limitations of the Accounts Payables Turnover
Ratio
While creditors will view a higher accounts payable turnover ratio positively,
there are caveats. If a company has a higher ratio during an accounting period
than its peers in any given industry, it could be a red flag that it is not
managing cash flow as well as the industry average. If a company does not
believe this is the case, finance leaders may wish to have an explanation on
hand.

4 Tips to Improve Your Accounts Payable (AP)

Turnover Ratio
1. Audit how your organisation is managing its cash flow, and determine
what impact reducing days payable outstanding might have.
2. Evaluate your accounts receivable turnover ratio and determine if
delays in collections are having an impact on your ability to cover
expenses.
3. Determine if you can improve your line of credit terms with suppliers.
4. Measure the cost of goods sold, and determine if there’s room for
improvement.
Unearned Revenue
Let us go through the sequence of events to explain unearned revenue:
 1) Unearned revenue is when a company receives cash to deliver a service or goods in the
near future. It is the portion of revenues collected in advance that has not yet been earned
at the end of the accounting period (month, year).
 2) As a result of this receipt of cash, the company has a liability equal to the revenue
that will be earned when the services or goods are delivered. This liability is reflected
under current liabilities, as it is expected to be cleared within a year. If the business is
unable to render the service, it must clear this liability by refunding money to its
customers. 
 3) Once the company renders the services for which customers have paid in advance, it
will be earning the revenue. At the end of the accounting period, the liability account
(unearned revenue) will decrease and the revenue will increase.  
Unearned revenue is also referred to as deferred revenue and advance payments received.
The following example will shed light on a simple business transaction relating to unearned
revenue:
Example
On December 1, BBS Company received in cash $9,000 in advance to deliver a project desiogn
within one month.
So the item ‘unearned revenue’ – a current liability item was created when the $9,000 cash was
received; and cash items increased by $9,000. Both are balance sheet items.

On December 28, BBS company delivered the project design, that means that BBS earned its
revenue. The item ‘unearned revenue’ is no more there (decreased) or is cleared, and the item
earned revenue is created under the income statement. 

This is as if you are converting a liability into a revenue having delivered the service.

Short-Term Notes Payable

Note Payable
A note payable is a legal document representing a loan made from an issuer to a creditor for the
purposes of purchasing vehicle, machines, merchandise, or in replacement of an account payable.

Notes entail that the borrower will pay back the principal amount loaned, as well as any
predetermined (interest rate specified) interest payments. 

Notes payable usually are issued when bank loans are obtained. Other transactions that may give
rise to notes payable include the purchase of real estate or costly equipment; purchase of
merchandise; substitution of a note for a past-due account payable.

Short-term debts (or short-term borrowings) typically include short-term bank loans,

commercial paper, lines of credit, and current maturities of long-term debt. Commercial

paper, a popular means of providing short-term financing, represents short-term notes (30

to 270 days) issued for cash by companies with good credit ratings to other companies. A

line of credit is usually granted to a company by a bank or group of banks, allowing it to

borrow up to a certain maximum dollar amount, interest being charged only on the

outstanding balance. Issued commercial paper and existing lines of credit are an

indication of a company’s ability to borrow funds on a short-term basis; thus, they are

very important to investors and creditors who are interested in assessing solvency.

Consequently, such financing arrangements are extensively described in the footnotes.

Short-Term Notes Payable

Short-term notes usually arise from cash loans and are generally payable to banks or loan

companies. In most cases, the life of a note is somewhere between 30 days and one year,

and the bank or loan company lends the borrowing company less cash than is indicated

on the face of the note. At the maturity date (when the loan is due), the borrowing

company pays the lending institution the face amount of the note, and the difference

between the face amount and the amount of the loan is treated as interest.

Pratt, 2020. [1]

Short-term debts (or short-term borrowings) typically include short-term bank loans,
commercial paper, lines of credit, and current maturities of long-term debt. Commercial
paper, a popular means of providing short-term financing, represents short-term notes (30
to 270 days) issued for cash by companies with good credit ratings to other companies. A
line of credit is usually granted to a company by a bank or group of banks, allowing it to
borrow up to a certain maximum dollar amount, interest being charged only on the
outstanding balance. Issued commercial paper and existing lines of credit are an
indication of a company’s ability to borrow funds on a short-term basis; thus, they are
very important to investors and creditors who are interested in assessing solvency.
Consequently, such financing arrangements are extensively described in the footnotes.
Short-Term Notes Payable
Short-term notes usually arise from cash loans and are generally payable to banks or loan
companies. In most cases, the life of a note is somewhere between 30 days and one year,
and the bank or loan company lends the borrowing company less cash than is indicated
on the face of the note. At the maturity date (when the loan is due), the borrowing
company pays the lending institution the face amount of the note, and the difference
between the face amount and the amount of the loan is treated as interest.
Pratt, 2020. [1]
Other Payables 
Accrued liabilities are current liabilities and are to be paid within a 12-month period. Examples
are employee wages, rent, and interest payments on debt owed to banks.

The other side of the business is accruing unpaid expenses are expenses that will be paid in the
near future.

More examples include salaries payable, rent payable, interest payable, insurance payable and
income taxes payable.

Accounts Payable (AP) Defined

Accounts payable (AP) is an accounting term used to describe the money owed to vendors or
suppliers for goods or services purchased on credit. The sum of any and all outstanding payments
owed by one organization to its suppliers is recorded as the balance of accounts payable on the
company’s balance sheet, whereas the increase or decrease in total AP from the period prior will
appear on the cash flow statement

It is important to pay close attention to your AP expenditures and maintain internal controls to

protect your cash and assets and avoid paying for inaccurate invoices. Maintaining an organized
and well-run accounts payable process is key so you remain aware of the effect AP has on your
bottom line.

In this post we will answer the following questions:

 What is an Accounts Payable Invoice?

 What Does Accounts Payable Do?
 What is an Example of Accounts Payable Expenses?
 What is the Accounts Payable Process?
 What is the Invoice Management Process?
 What is the Relationship Between Cash Flow and Accounts Payable?
 What is Accounts Payable vs. Accounts Receivable?
 What’s the Difference Between Accounts Payable and Trade Payables?
 Is Accounts Payable a Liability or an Expense?
 Is Accounts Payable a Debit or Credit Entry?
 How is Accounts Payable Listed on a Balance Sheet?
 Why Automate Accounts Payable?

What is an Accounts Payable Invoice?

An accounts payable invoice is a request for payment sent from a supplier to the accounts
payable department. These invoices are generally outstanding amounts for particular goods or
services purchased.

What Does Accounts Payable Do?

The role of the accounts payable department is to provide financial, administrative, and clerical
support to an organization: This team is responsible for managing the entire process of accounts
payable. This is a role critical to the accounting branch of the company and involves the coding,
approval, payment, and reconciliation of vendor invoices.

Each responsibility of the accounts payable team helps to improve the payment process and
ensure payments are only made on legitimate and accurate bills and invoices. A knowledgeable
and well-managed accounts payable department can save your organization considerable
amounts of time and money with regard to the AP process.

Armed with automation capabilities, AP teams can easily decide when to pay invoices (to avoid
late fees or capitalize on early pay discounts) as well as how to pay (via paper check, ACH, or
through virtual cards where you earn cash-back rebates). Organizations, in turn, gain more
control over outgoing cash and can even transform AP from a cost center to a profit center.
What is an Example of Accounts Payable Expenses?

Accounts payable differ from other types of current liabilities like short-term loans, accruals,
proposed dividends and bills of exchange payable. Examples of accounts payable expenses may
include (but are not limited to) things like:

 Transportation and Logistics

 Raw Materials
 Power / Energy / Fuel
 Products and Equipment
 Leasing
 Licensing
 Services (Assembly / Subcontracting)

Should any of the goods or services listed above be purchased on credit by your organization, it
is important to immediately record the amount to AP. This will ensure your balance sheet is kept
up-to-date and accurately reports on the total amount owed to your vendors, enabling
transparency in your book keeping efforts and accounting process.

What is the Accounts Payable Process?

The end-to-end process of accounts payable includes four distinct steps:

1. Invoice Capture: Typically, invoice capture involves the manual entering of invoice data
(vendor details, line items, amounts, and GL coding) into a system of record. This
presents risks associated with accuracy and human error.
2. Invoice Approval: Invoice approval involves the review and approval of supplier
invoices. Often, someone from the AP team literally walks the paper invoice around the
office to obtain the necessary approvals. This happens prior to posting as a cost in the
ERP and sending payment.
3. Payment Authorization: Once you have an invoice that is ready for payment, you must
get authorization to make the payment. This includes the date you will submit the
payment, the payment method, and the payment amount.
4. Payment Execution: Following payment authorization, the invoice is paid and
remittance details are sent to the vendor. Oftentimes this involves printing, signing, and
mailing checks, initiating ACH with the bank, or completing credit card payments. Now
the invoice can be closed out of the system and filed into various repositories.
A manual, paper-based accounts payable process can result in inaccurate performance and
financial reporting, and can prevent team members from working on higher-value activities that
could contribute to your bottom line. Inefficiencies caused by inevitable human error can
additionally result in late payments, missed opportunities (ex. discounts for early bill pay), and
inaccurate payments.

The manual AP process may also increase a company’s risk for AP fraud or business email
compromise (BEC). For these reasons, it is important to have a team or accounts payable system
that is up-to-date and well-run to ensure that your organization is not missing out on
opportunities or reporting inaccurate financials.

Three major elements are typically required for execution within the accounts payable process –
the purchase order (PO), receiving report (or goods receipt), and vendor invoice. However, PO
and receipts are optional and are dependent on how the company runs its business.

 The purchase order, used to initiate a purchase, is sent from the purchasing department
of an organization to a vendor: The PO will include a list of the requested merchandise,
quantities of each item requested, and a final price for the order.
 Once the purchasing organization receives the merchandise, a receiving report is drawn
up to document the shipment: This report will include any damages or quantity
discrepancies associated with the order.
 Finally, the vendor invoice is sent by the vendor to the purchasing organization to
request payment for the goods or services provided. Accounts payable receives the
vendor invoices and begins the invoice management process.

Often accounting clerks will manually match invoice line items against the PO and/or receipt line
items by comparing the documents side-by-side as a part of the invoice management process.
This method is time and resource-intensive without an accounts payable automation platform.

 
The Role of Internal Controls and Audits in the Account Payable Process

82% of organizations were subject to successful fraud in 2019 due to poor internal controls and
audits. Having sufficient operating procedures is extremely important to reduce improper
payments, ensure regulatory compliance, and reduce the risk of human error.

Additionally, internal controls and audits are required to ensure safety and security among your
organization. Having internal controls helps mitigate risk by creating a system of checks and
balances within your AP department–systems that monitor the data entry controls, payment entry
controls, and obligation to pay controls. Each of these internal controls are in place to keep your
payments safe and avoid human error within your organization.

Interested in learning more? Check out The 2021 State of AP Report

DOWNLOAD NOW

What is Invoice Management Process?

Also known as invoice processing, invoice management is the process by which organizations
track and pay vendor invoices. This process involves invoice capture, validation, payment, and
recording the payment in the company’s ERP or accounting system.
What is Accounts Payable vs. Accounts Receivable?

Accounts receivable (AR) is the opposite of accounts payable. AR is the money a company
expects to receive from customers and AP is the money a company owes to its vendors. For
example, when your business purchases goods from a vendor on credit, you will record the entry
to accounts payable and the vendor will record the transaction to accounts receivable.

What is the Difference Between Accounts Payable and Trade Payables?

Accounts payable and trade payables often get used interchangeably, but the two terms have
slightly different meanings. Trade payables refers to the money owed to vendors for inventory,
such as business materials, supplies, etc. Accounts payable refers to the accrued payments or
obligations that a business owes, such as electricity, labor, leasing, etc.

Is Accounts Payable a Liability or an Expense?

Accounts payable is a liability since it is money owed to one or many creditors. Accounts
payable is shown on a businesses balance sheet, while expenses are shown on an income
statement.

Is Accounts Payable a Debit or Credit Entry?

Since accounts payable is a liability, it should have credit entry. This credit balance then
indicates the money owed to a supplier. When a company pays their supplier, the company needs
to debit accounts payable so that the credit balance can be decreased.
How is Accounts Payable Recorded on a Balance Sheet?

Accounts payable is listed on a businesses balance sheet, and since it is a liability, the money
owed to creditors is listed under “current liabilities”. Typically, current liabilities are short-term
liabilities and less than 90 days.

What is the Relationship Between Cash Flow and Accounts Payable?

For any purchasing organization, accounts payable is recorded as a short-term liability in the
balance sheet. Over time, the manner by which accounts payable is handled can have a major
impact on cash flow.

Accounts payable is considered to be a source of cash, meaning that if accounts payable is

managed properly, organizations can take advantage of supplier agreements and increase cash
flow and cash on hand. Business managers and accountants may reference their accounts payable
and manipulate their cash flow accordingly to achieve specific outcomes.

For example, your company may be starting on a new project that requires your cash reserves to
be as sound and healthy as possible. In order to allocate more funds to the project, management
could abstain from paying outstanding AP for a period of time: While this is okay in the short
term, it is important to keep in mind that this form of cash manipulation may result in long-term
damaging effects to vendor relationships or business reputation. Taking steps to

Why Automate Accounts Payable?

Every company receives invoices and makes payments to vendors. However, processing these
invoices and paying bills manually requires a considerable amount of time and is particularly
costly. On average, it costs $12-15 to manually process an invoice, plus an additional $5 to pay
via paper check. Manual accounts payable can additionally place a strain on visibility and
operational resources and can burden the accounting team.

Using accounts payable automation, organizations can improve inefficiencies associated with the
manual AP process and reduce hard and soft costs up to 80%. AP automation streamlines your
accounts payable process from invoice capture to payment execution and keeps your information
up-to-date and ready to use. With AP automation solutions like MineralTree, your accounts
payable process becomes faster, easier, and more secure – saving your organization two valuable
resources: both money and time.

Days Payable Outstanding (DPO) Defined and How It's

Calculated
By 
ADAM HAYES
 

Updated March 28, 2022

Reviewed by 
MICHAEL J BOYLE

Fact checked by 

ARIEL COURAGE
Investopedia / Joules Garcia

What Is Days Payable Outstanding (DPO)?

Days payable outstanding (DPO) is a financial ratio that indicates the average
time (in days) that a company takes to pay its bills and invoices to its trade
creditors, which may include suppliers, vendors, or financiers. The ratio is
typically calculated on a quarterly or annual basis, and it indicates how well
the company’s cash outflows are being managed.
A company with a higher value of DPO takes longer to pay its bills, which
means that it can retain available funds for a longer duration, allowing the
company an opportunity to use those funds in a better way to maximize the
benefits. A high DPO, however, may also be a red flag indicating an inability
to pay its bills on time.

KEY TAKEAWAYS

 Days payable outstanding (DPO) computes the average number of

days a company needs to pay its bills and obligations.
 Companies that have a high DPO can delay making payments and use
the available cash for short-term investments as well as to increase
their working capital and free cash flow.
 However, higher values of DPO, though desirable, may not always be a
positive for the business as it may signal a cash shortfall and inability to
pay.
0 seconds of 1 minute, 53 secondsVolume 75%
 

1:53

Days Payable Outstanding

Formula for Days Payable Outstanding (DPO)

\begin{aligned} &\text{DPO} = \frac{\text{Accounts Payable}\
times\text{Number of Days}}{\text{COGS}}\\ &\textbf{where:}\\ &\
text{COGS}=\text{Cost of Goods Sold} \\ &\qquad\ \ \, \,= \
text{Beginning Inventory} + \text{P} -\text{Ending Inventory}\\ &\
text{P}=\text{Purchases} \end{aligned}
DPO=COGSAccounts Payable×Number of Dayswhere:COGS=Cost 
of Goods Sold  =Beginning Inventory+P−Ending InventoryP=Purchas
es
How To Calculate DPO
To manufacture a salable product, a company needs raw material, utilities,
and other resources. In terms of accounting practices, the accounts payable
represents how much money the company owes to its supplier(s) for
purchases made on credit.

Additionally, there is a cost associated with manufacturing the salable

product, and it includes payment for utilities like electricity and employee
wages. This is represented by cost of goods sold (COGS), which is defined
as the cost of acquiring or manufacturing the products that a company sells
during a period. Both of these figures represent cash outflows and are used
in calculating DPO over a period of time.

The number of days in the corresponding period is usually taken as 365 for a
year and 90 for a quarter. The formula takes account of the average per day
cost being borne by the company for manufacturing a salable product. The
numerator figure represents payments outstanding. The net factor gives the
average number of days taken by the company to pay off its obligations after
receiving the bills.

Two different versions of the DPO formula are used depending upon the
accounting practices. In one of the versions, the accounts payable amount is
taken as the figure reported at the end of the accounting period, like “at the
end of fiscal year/quarter ending Sept. 30.” This version represents the DPO
value as of the mentioned date.

In another version, the average value of beginning AP and ending AP is

taken, and the resulting figure represents the DPO value during that particular
period. COGS remains the same in both versions.

What Does DPO Tell You?

Generally, a company acquires inventory, utilities, and other necessary
services on credit. It results in accounts payable (AP), a key accounting entry
that represents a company's obligation to pay off the short-term liabilities to
its creditors or suppliers. Beyond the actual dollar amount to be paid, the
timing of the payments—from the date of receiving the bill till the cash
actually going out of the company’s account—also becomes an important
aspect of the business. DPO attempts to measure this average time cycle for
outward payments and is calculated by taking the standard accounting
figures into consideration over a specified period of time.

Companies having high DPO can use the available cash for short-term
investments and to increase their working capital and free cash flow (FCF).
However, higher values of DPO may not always be a positive for the
business. If the company takes too long to pay its creditors, it risks
jeopardizing its relations with the suppliers and creditors who may refuse to
offer the trade credit in the future or may offer it on terms that may be less
favorable to the company. The company may also be losing out on any
discounts on timely payments, if available, and it may be paying more than
necessary.

Additionally, a company may need to balance its outflow tenure with that of
the inflow. Imagine if a company allows a 90-day period for its customers to
pay for the goods they purchase but has only a 30-day window to pay its
suppliers and vendors. This mismatch will result in the company being prone
to cash crunch frequently. Companies must strike a delicate balance with
DPO.

 
A high DPO can indicate a company that is using capital resourcefully but it
can also show that the company is struggling to pay its creditors.

Special Considerations
Typical DPO values vary widely across different industry sectors and it is not
worthwhile comparing these values across different sector companies. A
firm's management will instead compare its DPO to the average within its
industry to see if it is paying its vendors too quickly or too slowly. Depending
upon the various global and local factors, like the overall performance of the
economy, region, and sector, plus any applicable seasonal impacts, the DPO
value of a particular company can vary significantly from year to year,
company to company, and industry to industry.

DPO value also forms an integral part of the formula used for calculating
the cash conversion cycle (CCC), another key metric that expresses the
length of time that a company takes to convert the resource inputs into
realized cash flows from sales. While DPO focuses on the current
outstanding payable by the business, the superset CCC follows the entire
cash time-cycle as the cash is first converted into inventory, expenses,
and accounts payable, through to sales and accounts receivable, and then
back into cash in hand when received.

Example of How DPO Is Used

As a historical example, the leading retail corporation Walmart (WMT) had
accounts payable worth $49.1 billion and cost of sales (cost of goods sold)
worth $420.3 billion for the fiscal year ending Jan. 31, 2021.1 These figures
are available in the annual financial statement and balance sheet of the
company. Taking the number of days as 365 for annual calculation, the DPO
for Walmart comes to [ (49.1 x 365) / 420.1 ] = 42.7 days.

Similar calculations can be used for technology leader Microsoft (MSFT),

which had $2.8 billion as AP and $41.3 billion as COGS, leading to a DPO
value of 24.7 days.2

It indicates that during the fiscal year ending in 2021, Walmart paid its
invoices around 43 days after receiving the bills, while Microsoft took around
25 days, on average, to pay its bills.

A look at similar figures for the online retail giant Amazon (AMZN), which had
an AP of $72.5 billion and COGS of $233.3 billion for the fiscal year 2020,
reveals a very high value of 113.4 days. Such high value of DPO is attributed
to the working model of Amazon, which roughly has 50% of its sales being
supplied by third-party sellers.3 Amazon instantly receives funds in its
account for the sale of goods that are actually supplied by third-party sellers
using Amazon’s online platform.

However, it doesn’t pay the sellers immediately after the sale but may send
accumulated payments based on a weekly/monthly or threshold-based
payment cycle. This working mechanism allows Amazon to hold onto the
cash for a longer period of time, and the leading online retailer ends up with a
significantly higher DPO.

Limitations of DPO
While DPO is useful in comparing relative strength among companies, there
is no clear-cut figure for what constitutes a healthy days payable outstanding,
as the DPO varies significantly by industry, competitive positioning of the
company, and its bargaining power. Large companies with a strong power of
negotiation are able to contract for better terms with suppliers and creditors,
effectively producing lower DPO figures than they would have otherwise.

What Does Days Payable Outstanding Mean in Accounting?

As a financial ratio, days of payable outstanding (DPO) shows the amount of
time that companies take to pay financiers, creditors, vendors, or suppliers.
The DPO may indicate a few things, namely, how a company is managing its
cash, or the means for a company to utilize this cash towards short-term
investments that in turn may amplify their cash flow. The DPO is measured
on a quarterly or annual term.

How Do You Calculate Days Payable Outstanding?

To calculate days of payable outstanding (DPO), the following formula is
applied: DPO = Accounts Payable X Number of Days/Cost of Goods Sold
(COGS). Here, COGS refers to beginning inventory plus purchases
subtracting the ending inventory. Accounts payable, on the other hand, refers
to company purchases that were made on credit that are due to its suppliers.

What Is the Difference Between DPO and DSO?

Days payable outstanding (DPO) is the average time for a company to pay its
bills. By contrast, days sales outstanding (DSO) is the average length of time
for sales to be paid back to the company. When a DSO is high, it indicates
that the company is waiting extended periods to collect money for products
that it sold on credit. By contrast, a high DPO could be interpreted multiple
ways, either indicating that the company is utilizing its cash on hand to create
more working capital, or indicating poor management of free cash flow.

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Dividends Payable
In order to understand dividends payable, you need to understand what are dividends. 

We can start by watching the videos below:

What should we know about dividends?
 1

1
A dividend is the distribution of a company’s profits to qualified shareholders.

 2

2
Dividend payments and amounts are resolved and declared by a company's board of
directors.

 3

3
Dividends are payments made to remunerate shareholders/investors for investing their
money into the company.

 4

4
Announcements/declarations of dividend payouts are generally accompanied by a
proportional increase or decrease in a company's stock price.
 5
5
Companies might not pay dividends but keep the retained earnings to be invested back
into the company.
Let us go through the below sequence of events to explain dividends payable:
 1) Dividends payable is a current liability created when the board of directors of a
company declares a dividend to be paid to the shareholders. 
 2) Accounts involved with this business decision are:
1. Dividends – this account is created and reflected under the retained earnings
section of the shareholders’ equity (balance sheet) as a DEDUCTION. That is, it
is deducted from the company’s retained earnings account to be distributed to the
shareholders. 
 2.  Dividends payable account is reflected under current liabilities – balance sheet.
The dividends payable account is used for the time between when dividends are
declared and when the actual payments are made.
 3) After cash dividend payments are made there are no separate dividend or dividend-
related accounts left on the balance sheet. 

Notes to remember: 

1. Dividends are reflected under the statement of stockholders' equity as a

subtraction from retained earnings.
2. Dividends are NOT expenses, they might be considered as a contra equity
account.
3. Dividends paid for a reporting period are reflected under the financing
section of the statement of cash flows. Dividends paid is reflected as a use of
cash (cash outflow). 

+VIDEO Dividend policy…

Contingencies and Contingent Liabilities

What should we know about contingencies?
 A contingency is a potentially negative event that may occur in the future, such as
an economic recession, natural disaster, or fraudulent activity.
 Companies and investors plan for various contingencies through analysis and
implementing protective measures.
 A thorough contingency plan minimizes loss and damage caused by an unforeseen
negative event.
 Contingency plans can include the purchase of options or insurance for investment
portfolios.
 Banks must set aside a percentage of capital for negative contingencies, such as a
recession, to protect the bank against losses.

Investopedia [1].

 A contingency is a potentially negative event that may occur in the future, such as
an economic recession, natural disaster, or fraudulent activity.
 Companies and investors plan for various contingencies through analysis and
implementing protective measures.
 A thorough contingency plan minimizes loss and damage caused by an unforeseen
negative event.
 Contingency plans can include the purchase of options or insurance for investment
portfolios.
 Banks must set aside a percentage of capital for negative contingencies, such as a
recession, to protect the bank against losses.
Investopedia [1].
Set aside the time to watch over the following videos:

Non-Current Liabilities
Noncurrent liabilities/long-term liabilities, are long-term financial obligations reflected
on a company’s balance sheet that are due after one year. 

Several ratios using noncurrent liabilities are used to assess a company’s leverage, such
as debt-to-assets and debt-to-capital. Examples: long-term loans, and bonds payable. 

Long-Term Liabilities: Bondsthe following statements:

 To raise capital, companies sell bonds to the public.
 Bonds payable are groups of notes payable issued to multiple lenders, called bondholders.

Time value of money

Lets consider some finance concepts:

Money earns interest over time: $1 received tomorrow is worth less than $1 received today.

Future value vs. present value:

1. Calculating FV is called accumulating, because the FV of $1 is more than $1

today.
2. Calculating PV is called discounting, because the PV of $1 (in the future) is
less than $1 today.

Present value and future value calculations depend on 4 factors:

1. Amount of investment (or receipt).

2. Length of time between ‘present’ and ‘future’.
3. Interest rate.
4. Frequency of interest compounding (i.e. earning interest on interest).

‘Lump sum’ vs. annuity: annuity – multiple investments (or receipts) of an equal periodic
amount at fixed intervals.
Basic Principles
Basic information for alternative issues of a 2 year $1,000 bond, payable annually in arrears:
  Premium   Par  Discount
Coupon Rate 10% 10% 10%
(CR) 
   >   =   <
Market Rate ( r ) 8% 10% 12%
Face value $1,000  $1,000  $1,000 
Present Value $1,036  $1,000  $966 

Bonds are issued either:

 At par: Price = Face Value if CR = r.

 At a discount: Price < less Face Value if CR < less r.
 At a premium: Price > greater Face value if CR > greater r.

Keep in mind: 

1) Companies might use long-term debt to finance growth and expansion, however, care should
be taken as to use the funds within the company to earn a return higher than the rate of interest
paid to creditors.

Relationship of return on Assets to Interest rate on borrowed funds Effect on Net income and retur
equity
Return on Assets > Interest rates being paid Increase
Return on Assets <  Interest rates being paid Decrease

2) Discount, Par and Premium, comparison.

  Discount  Par  Premium

Rates   Int. rate > coupon rate   Int. rate = coupon rate   Int. rate < coupon rate
Values   Price < Face Value Price = Face Value Price > Face Value
  Creates Discount    Creates Premium
Change over time Difference between No change in bond Difference between
  interest and coupon value over time interest and coupon
  removes (is added to)   removes (is subtracted
  the discount, and   from) premium, and
  increases the bond   decreases the bond
  value over time   value over time
Key Takeaways
1. Liabilities: Important to keep in mind that the claims of creditors have legal
priority and significance over the claims of owners.
2. In case a company ceases operations and liquidates, creditors are the first to
be paid in full before any distributions to the owners.

Understanding the nature of liabilities and appropriate recording of them in financial

statements is important for a business. It is especially important to management as they

have to take decisions to manage working capital based on what the company owes and
when are they owed. For investors as well, analysis of liabilities helps them gauge the

financial strength of the company.

Terms compared [1].

Understanding the nature of liabilities and appropriate recording of them in financial
statements is important for a business. It is especially important to management as they
have to take decisions to manage working capital based on what the company owes and
when are they owed. For investors as well, analysis of liabilities helps them gauge the
financial strength of the company.
Terms compared [1].
  CURRENT LIABILITIES     NONCURRENT LIABILITIES
Meaning
Liabilities which are due for payment within one Liabilities which are not due for payment within one
financial year financial year
Credit period/term
Up to a year More than a year
Presentation in the balance sheet
Generally in only one balance sheet Across several consecutive balance sheets
Impact of repayment on working capital
Yes No, (interest payment impacts working capital).
Accrued due to
Goods and services availed during day to day Generally due to funding of long term capital expense
operations of a business
Interest obligation attached
No Yes
Security
Generally no Yes
Example
Short term accounts and utility payables, short term Long term borrowings including bonds and debenture
borrowings
...
Under the balance sheet, the assets of a company belong to the company itself.

The company is responsible for its own debts and must pay its obligations and income
taxes on its earnings.

The company is a legal separate entity, it has status in court; it may enter into contracts,
and it may sue and be sued.

Shareholders’ equity reflects the amount the owners of a company have invested in the
business—by investing money in it and/or by accumulating retaining earnings.

In this lesson, we will consider the balance sheet formula/equation again, reflecting the
shareholder equity calculations:

Shareholder Equity =Total Assets – Total Liabilities.

Dr. Sonia Hajjar 

Under the balance sheet, the assets of a company belong to the company itself.
The company is responsible for its own debts and must pay its obligations and income taxes on
its earnings.

The company is a legal separate entity, it has status in court; it may enter into contracts, and it
may sue and be sued.

Shareholders’ equity reflects the amount the owners of a company have invested in the business
—by investing money in it and/or by accumulating retaining earnings.

In this lesson, we will consider the balance sheet formula/equation again, reflecting the
shareholder equity calculations:

Shareholder Equity =Total Assets – Total Liabilities.

Dr. Sonia Hajjar 
CONTINUE

t's look at the basic accounting equation again:

Total Assets = Total Liabilities+ Shareholder Equity

Companies generate assets from three sources:

1. Borrowings (liabilities).
2. Issuing equity securities (shareholders’ equity).
3. Retaining funds generated through profitable operations(shareholders’
equity).

Each of these sources is represented on the right side of the basic accounting equation (balance
sheet) below:
Assets = (1) Liabilities + Shareholders’ Equity
  (2) Contributed Capital (3) Earned Capital

 Preferred Stock  Retained Earnings

 Common Stock  Accumulated Comprehen
 Additional Paid-in Capital Income

The basic accounting equation [1].

Shareholders’ equity is a major source of resources for a company. Shareholders’ equity comes
from two primary sources:

 1

The original contributions of Shareholders when they purchase shares of

common or preferred stock directly from the company.
 2
2
 The company’s accumulated earnings, less dividends since the company’s
inception.
Generally, on the balance sheet, shareholders’ equity is broken down into three categories:
common shares, preferred shares and retained earnings.

Characteristics of Debt
When a company borrows money, it establishes a relationship with an outside party, a

creditor or debtholder, whose influence on the company’s operations is defined by a

formal legal contract containing a number of specific provisions. These provisions are

summarized here-below, along with characteristics of equity.

Pratt 2020, [1].

When a company borrows money, it establishes a relationship with an outside party, a
creditor or debtholder, whose influence on the company’s operations is defined by a
formal legal contract containing a number of specific provisions. These provisions are
summarized here-below, along with characteristics of equity.
Pratt 2020, [1].
Debt Equity
1. Formal legal contract 1. No legal contract
2. Fixed maturity date 2. No fixed maturity date
3. Fixed periodic payments 3. Discretionary dividends
4. Security in case of default 4. Residual asset interest
5. No voice in management 5. Voting rights  - common
6. Interest expense deductible 6. Dividends not deductible
7. Double taxation

Debt and equity distinguished – characteristics [2].

Lets consider the following example [3]:
Example
In 2020, Nordstrom entered into the following activities. 

1. Nordstrom issued $29 million of common stock to employees in support of compensation plans.
2. Nordstrom reported profits of $496 million but only distributed $229 million in the form of
dividends.
3. Nordstrom collected $499 million, most of which came from issuing senior notes with a 4.375
percent annual effective interest rate due April 2030.

Can you classify each activity as financing with debt, equity, or retained
earnings?
Consider how you might answer the question before revealing the answer below:
Reveal the answer
–
1. Equity
2. Retained earnings
 3. Debt

Distinctions between Debt and Equity

The table below reflects, in simple terms, the distinctions between debt and equity for the
interested party. Let us analyze the investors who are contributing for the capital of the company;
their money or investment is on a higher risk level than a debt, since the return they are
expecting (dividends, for example) is variable and dependent on the successful operations of the
company.

If we take the same amount of money from the same parties, but use it to purchase bonds, then
their investment is at a lower risk, and they will be receiving fixed amounts of money at
determined periods.
Interested Party                  Debt                                   Equity

Investors/Creditors Lower investment risk Higher investment risk

Fixed cash receipts Variable cash receipts

Management Contractual future cash payments Dividends are discretionary

Effects on credit rating Effects of dilution/takeover
Interest is tax deductible Dividends are not tax deductible

Accountants/Auditors Liabilities section of the balance sheet Shareholders’ equity of the balance sh
Income statement effects from debt No income statement effects from equ

Distinctions between Debt and Equity [1].

Preferred Stock vs. Common Stock:

–
What should we know about preferred stock and common stock? 

Have a look at the table below that includes the advantages and disadvantage of the preferred
stock and the common stock: 

  Preferred Stock Common Stock

Advantages  Preference over common in Voting Rights.
liquidation. Rights to residual profits (after preferred).
Stated dividend.   
Preference over common in
dividend pay-out.
  
  Last in liquidation.
Disadvantages Subordinate to debt in liquidation. No guaranteed return.
Stated dividend can be skipped.   
No voting rights (versus common).
  
Debt or    
Equity?  Components of both.  Equity.
Usually classified as equity.

Preferred Stock vs. Common Stock [1].

Which company shares would you purchase if you have $100,000 and why?
Par value (or stated value) of the stock
–
As you watched the videos, you came across the par value of the stock which indicates the legal
capital per share, the amount per share to be entered in the capital stock account, and below
which the stockholders’ equity cannot fall, except by losses from business operations.  

The market values might be above their par values. Any amount received by the company in
excess of the par is titled ‘additional paid-in capital’.

Lets consider the following example:

Example

Company BIVI is authorized 60,000 shares, however, they issued 10,000 shares of $2 par value stock at a price of $8 per
share.

Review the stockholders' equity table below and notice how the capital stock amount is presented: Par value $2 multiplied
by the number of shares issued and outstanding of 10,000 = $20,000.

Since they sold the share for $8, that means $6 above the par (8-2=6), then this amount which is $6 multiplied by 10,000
shares = $60,000 is the additional paid-in capital. It is the amount received over and above the par value.

The additional paid-in capital does not represent a profit to the corporation. It is part of the invested capital, and it is added
to the capital stock in the balance sheet to show the total paid-in capital as reflected in the partial stockholders’ equity table
below:

Stockholders’ equity:  
Capital stock, $2 par value; authorized, 60,000 shares; issued and outstanding, 10,000 $20,000 
shares ($2 x 10,000)
Additional paid-in capital ($8-$2 par = $6 x 10,000)   60,000
Total paid-in capital $80,000

Preferred Stock, Common Stock, and Treasury Stock

After watching the videos on the previous page, you should now be familiar with the preferred
and common stock. 
Let us reflect on some key points:
Characteristics of preferred stock:

1. Cumulative dividend rights in which unpaid dividends carry forward to future periods.
2. Preference over common stock as to assets in the event of liquidation of the company.
3. Call feature that allows the corporation to repurchase its own stock.
4. The absence of voting power.

Characteristics of common stock:  

1. The basic type of capital stock is the common stock.

2. Rights of ownership including voting rights, participation in dividends and residual claim to
assets in the event of a liquidation.

Presentation of a partial equity section of the balance sheet

Consider that the preferred stock with a par value of $100 was sold at $110 per share, and the
common stock with a par value of $5 was sold at $15 per share.

Stockholders’ equity:  
9% cumulative preferred stock, $100 par value, authorized 200,000 shares, issued and $5,000
outstanding 50,000 shares ($100 x 50,000 = $5,000,000)
Common stock, $5 par value, authorized 4 million shares, issued and outstanding 2 10,000
million shares ($5 x2M=$10,000,000)
Additional paid-in capital:
Preferred stock ($110 – $100 = $10 x 50,000=$500,000) 500
Common stock ($15-$5=$10 x 2M=$20,000,000 20,000
Total paid-in capital $35,500
Note the presentation of the preferred stock, common stock and the additional paid-in capital of
both the preferred and common stock under the above partial stockholders’ equity.
Characteristics of treasury stock
Set aside some time to watch over the three videos below:
TREASURY STOCKWHY FIRMS BUY BACK THEIR OWN ...STOCK SPLI

In short, treasury stock is the company’s own capital stock that was issued and later reacquired
by the issuing company. These shares may be held indefinitely or may be issued again. They are
not entitled to receive dividends, vote, or share in assets upon dissolution of the company.

Some points to remember are captured in the table below:

Treasury stock is created when a company buys back shares of its own common stock.
Reasons for buyback are numerous and include:
- Support compensation plans.
- Maintain leverage.
- Raise EPS.
- Return money to shareholders.
The debit balance account called Treasury stock is reported in shareholders’ equity as a contra account to SE. N
Treasury stock is not an asset.
The stock remains issued, but is no longer outstanding.
- Does not have voting rights.
- Cannot receive cash dividends.
 May be reissued (to the market or to employees) or retired.
No gains or losses are ever recognized from these equity transactions.

Retained Earnings
Retained earnings
Retained earnings refers to the accumulated profits earned by a company, less any dividends paid
in the past. 
An analogy may be a box that the company puts its profits into each year/period (assuming no
losses), and removes from as it takes out the dividends to be distributed to its shareholders. It's
key point is since profits were not all paid to the shareholders, then they were retained by the
company.
Note that retained earnings decrease when a company loses money or pays dividends and
increase with profits.

So, the retained earnings of a company is the amount available of net income (accumulation of
several years) after paying the dividends to its shareholders.

The management (Board) decides whether to keep or distribute the retained earnings to the
shareholders. Companies also can use the retained earnings to finance expansion. If a company is
looking for growth, dividends might be paid in small amounts, or might even not be paid.

Set aside the time to watch over the following videos:

Key Takeaways
In this lesson we analyzed, explained, and watched videos on the shareholder equity
section of the balance sheet, which is the owner's claim after subtracting total liabilities
from total assets.

What do we know?

1. Positive shareholder equity means the company has enough assets to

cover its liabilities.
2. Negative shareholder equity means the company's liabilities exceed its
assets.
3. Retained earnings is part of shareholder equity and is the amount of net
earnings not paid to shareholders as dividends.
4. Shareholder equity gives analysts and investors a clear picture of the
financial health of a company.
5. Shareholder equity is equal to a firm's total assets minus its total
liabilities. Retained earnings are part of shareholder equity as is any
capital invested into the company. This metric allows analysts and
investors to determine the value of company-related financial ratios,
providing them with the tools to make better, more well-informed
investment decisions.