Terms in Financial statements

Liabilities, defined very broadly represent what the firm owes others. A liability arises when a firm receives benefits or services and, in turn promises to pay cash at well-defined time in future or provide goods and services.

Most liabilities are monetary liabilities meaning that they require payments of specific amounts of cash. If the payment is due within a year or less, the liability is shown at the amount of cash the firm is expected to pay to discharge the obligation. If the payment dates extend beyond one year, the liability is shown at the present value of the future cash outflows. The discount rate used for valuing the future cash flows is the borrower’s interest rate on that liability.

Some liabilities are non-monetary, meaning that the firm expects to discharge them by delivering goods or providing services, rather than by paying cash. For example, a magazine publisher may collect cash for subscriptions and promise delivery of magazines for many months to come. While the firm receives cash currently, it discharges its obligation by delivering the magazines in future. Such non-monetary liabilities are shown at the amount of cash received, rather than the expected cost of publishing the magazines.

The format prescribed in the Companies Act classifies liabilities as follows:

1. Share capital
2. Reserves and surplus
3. Secured loans
4. Unsecured loans
5. Current liabilities and provisions

Share Capital includes equity (or ordinary) capital and preference capital. Equity capital represents the contribution of equity shareholders who are the owners of the firm. Equity capital being the risk capital carries no fixed rate of dividend. Preference capital represents the contribution of preference shareholders and the dividend rate payable on it is generally fixed.

While the final figure shown against share capital is the paid up capital, the balance sheet also provides information on authorized capital, issued capital, subscribed capital and paid-up capital. The amount of capital that a company can potentially issue as per its memorandum, represents the authorized capital; the amount offered by the company to the investors is called the issued capital; the past of issued capital which has been subscribed to by the investors is called subscribed capital; the actual amount paid up is called the paid-up capital. Typically, the issued, subscribed and paid up capital are the same.

Reserves and Surplus: Reserves and Surplus comprise retained earnings as well as non-earnings items like share premium and capital subsidy.

There are two broad kinds of reserves, viz. capital reserves and revenue reserves. Capital reserves include items such as share premium account, revaluation reserve, and capital redemption reserve. A capital reserves cannot be distributed as dividend to shareholders. Revenue reserves represent accumulated retained earnings from the profits of the business. They are held in accounts like investment allowance reserve, dividend equalization reserve, taxation reserve, and general reserves.

It is a common practice for companies to transfer from the profit and loss account to various reserve accounts. This process is called appropriation.

Surplus is the balance in the profit and loss account which has not been appropriated to any particular reserve account. Note that reserves and surplus along with paid up capital represent owners’ equity, which is also called shareholders equity or just equity.

Secured loans are loans that are secured by a charge on the assets of the firm. The charge may be created in the form of pledge or hypothecation of movable assets such as inventories and debtors and/or in the form of mortgage (usually equitable mortgage) of immovable assets such as land, buildings, plant and machinery (which are embedded to earth).

The most common forms of secured loans in India are Debentures, Term loans and working capital loans. Debentures are instruments for raising debt finance which have maturities ranging from one to ten years.

Unsecured Loans: In contrast to secured loans, unsecured loans are loans which are not secured by a charge on the assets of the firm.

The most common forms of unsecured loans in India are public deposits, commercial paper, unsecured loans from promoters, inter-corporate loans, and unsecured loans from commercial banks and financial institutions.

Current Liabilities and Provisions: Broadly speaking, current liabilities and provisions represent obligation that are expected to mature within a year.

As per the format prescribed under the Company’s Act, current liabilities and provisions are divided into two sub-categories, viz. current liabilities and provisions. Current liabilities include items such as bills payable. Sundry creditors, advance payments and interest accrued but not due on loans, provisions include items such as provision for taxes, provision for dividend and provision for provident fund, gratuity, superannuation and leave encashment.

Note that loans which are repayable within a year from the date of the balance sheet should also be part of current liabilities and provisions. However, in the format prescribed under the companies Act, loans are shown separately in two categories namely secured loans and unsecured loans. For managerial purposes, it makes sense to identify portions of loans whether secured or unsecured which are repayable within a year from the date of the balance sheet and include them under current liabilities and provisions.