BALANCE SHEET DEFINITIONS

ASSETS
Assets: An asset is a resource with economic value that an individual, corporation or country owns or
controls with the expectation that it will provide future benefit. Assets are reported on a company's
balance sheet, and they are bought or created to increase the value of a firm or benefit the firm's
operations. An asset can be thought of as something that in the future can generate cash flow, reduce
expenses, improve sales, regardless of whether it's a company's manufacturing equipment or a patent on
a particular technology. Assets can be broadly categorized into short-term (or current) assets, fixed assets,
financial investments and intangible assets. Assets are recorded on companies' balance sheets based on
the concept of historical cost, which represents the original cost of the asset, adjusted for any
improvements or aging. Historical cost is also called the book value.

Current assets are short-term economic resources that are expected to be converted into cash within one
year. Current assets include cash and cash equivalents, accounts receivable, inventory, and various
prepaid expenses. While cash is easy to value, accountants periodically reassess the recoverability of
inventory and accounts receivable. If there is persuasive evidence that collectability of accounts receivable
is impaired or that inventory becomes obsolete, companies may write off these assets.

Fixed assets are long-term resources, such as plants, equipment and buildings. An adjustment for aging
of fixed assets is made based on periodic charges called depreciation, which may or may not reflect the
loss of earning power of a fixed asset. Generally accepted accounting principles (GAAP) allow depreciation
under two broad methods: the straight-line method assumes that a fixed asset loses its value in proportion
to its useful life, while the accelerated method assumes that the asset loses its value faster in its first years
of use.

Financial assets represent investments in the assets and securities of other institutions. Financial assets
include stocks, sovereign and corporate bonds, preferred equity, and other hybrid securities. Financial
assets are valued depending on how the investment is categorized and the motive behind it.

Intangible assets are economic resources that have no physical presence. They include patents,
trademarks, copyrights and goodwill. Accounting for intangible assets differs depending on the type of
asset, and they can be either amortized or tested for impairment each year.

Cash and cash equivalents refer to the line item on the balance sheet that reports the value of a
company's assets that are cash or can be converted into cash immediately. These include bank accounts,
marketable securities, commercial paper, Treasury bills and short-term government bonds with a maturity
date of three months or less. Marketable securities and money market holdings are considered cash
equivalents because they are liquid and not subject to material fluctuations in value.

Marketable securities are financial instruments that are very liquid and can be quickly converted into cash
at a reasonable price. The liquidity of marketable securities comes from the fact that the maturities tend
to be less than one year, and that the rates at which they can be bought or sold have little effect on prices.
Examples of marketable securities include commercial paper, banker's acceptances, Treasury bills and
other money market instruments. Marketable securities are defined as any unrestricted financial
instrument that can be bought or sold on a public stock exchange or a public bond exchange. Therefore,
marketable securities are classified as either a marketable equity security or a marketable debt security.
Other requirements of marketable securities include having a strong secondary market that can facilitate

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quick buy and sell transactions, and having a secondary market that provides accurate price quotes for
investors. The return on these types of securities is low, due to the fact that marketable securities are
highly liquid and are considered safe investments.

Accounts receivable refers to the outstanding invoices a company has or the money the company is owed
from its clients. The phrase refers to accounts a business has a right to receive because it has delivered a
product or service. Receivables essentially represent a line of credit extended by a company and due
within a relatively short time period, ranging from a few days to a year. On a public company's balance
sheet, accounts receivable is often recorded as an asset, because there is a legal obligation for the
customer to remit cash for the debt. If a company has receivables, this means it has made a sale but has
yet to collect the money from the purchaser. Essentially, the company has accepted an IOU from its client.

Prepaid expenses are a type of asset that arises on a balance sheet as a result of business making
payments for goods and services to be received in the near future. While prepaid expenses are initially
recorded as assets, their value is expensed over time as the benefit is received onto the income statement,
because unlike conventional expenses, the business will receive something of value in the near future.
Due to the nature of certain goods and services, there must be prepaid expenses. For example, insurance
is a prepaid expense, because the purpose of purchasing insurance is to buy proactive protection in case
something unfortunate happens. Clearly, no insurance company would sell insurance that covers the
occurrence of an unfortunate event after the fact, so insurance expenses must be prepaid.

Inventory is the raw materials, work-in-process products and finished goods that are considered to be the
portion of a business's assets that are ready or will be ready for sale. Inventory represents one of the most
important assets of a business because the turnover of inventory represents one of the primary sources
of revenue generation and subsequent earnings for the company's shareholders. Inventory represents
finished goods or goods in different stages of production that a company keeps at its premises. Inventory
can also be on consignment, which is an arrangement when a company has its goods at third-party
locations with ownership interest retained until goods are sold. Inventory is reported on a company's
balance sheet under the current assets category, and it serves as a buffer between manufacturing and
order fulfillment. When an inventory is sold, its carrying cost goes into the cost of goods sold on the
income statement. There are three components typically classified under the inventory account: raw
materials, work in progress and finished goods. Raw materials represent goods that are used in the
production as a source material. Examples of raw materials are metal bought by car manufacturers, food
ingredients held by food preparation companies and crude oil held by refineries. Work in progress includes
goods that are in the process of being transformed during manufacturing and are about to be converted
into finished goods. For example, a half-assembled airliner or a ship that is being built would be work in
process. Finished goods are products that have gone through the production and ready for sale, such as
completed airliners, ready-to-ship cars and electronics. Retailers who buy and resell goods typically call
inventory "merchandise," which includes finished goods bought from producers and can be resold
immediately. Examples of merchandise include electronics, clothes and cars held by retailers. Accountants
value inventory using one of the three methods. The first-in, first-out (FIFO) method says that the cost of
goods sold is based on the cost of materials purchased the earliest, while the carrying cost of remaining
inventory is based on the cost of materials bought the latest. The last-in, first-out (LIFO) method states
that the cost of goods sold is valued using cost of materials bought latest, while the value of remaining
inventory is based on materials purchased earliest. The weighted average method requires valuing both

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inventory and the cost of goods sold based on the average cost of all materials bought during the period.
Possessing a high amount of inventory for a long time is usually not advantageous for a business because
of costly storage, the possibility of obsolescence and spoilage costs. However, possessing too little
inventory isn't beneficial either, since the business runs the risk of losing out on potential sales and
potential market share as well. Inventory management forecasts and strategies, such as a just-in-time (JIT)
inventory system, can help minimize inventory costs because goods are created or received only when
needed.

Property, plant and equipment (PP&E) is a company asset that is vital to business operations but cannot
be easily liquidated, and depending on the nature of a company's business, the total value of PP&E can
range from very low to extremely high compared to total assets. It is listed separately in most financial
statements because it is treated differently in accounting statements, and improvements, replacements
and betterments can pose accounting issues depending on how the costs are recorded. PP&E is also called
tangible fixed assets. These assets are physical, tangible assets and they are expected to generate
economic benefits for a company for a period of longer than one year. Examples of PP&E include land,
buildings and vehicles. Industries or businesses that require a large amount of fixed assets are described
as capital intensive. PP&E is recorded in a company's financial statements in the balance sheet. The cost
of PP&E considers the actual cost of purchasing and bringing the asset to its intended use. This cost is
called the historical cost. For example, when purchasing a building for a company to run its retail
operations, the historical cost could include the purchase price, transaction fees and any improvements
made to the building to bring it to its destined use. The value of PP&E is adjusted routinely as fixed assets
generally see a decline in value due to use and depreciation. Amortization is used to devalue these assets
as they are used, but land is not amortized because it can increase in value. Instead, it is represented at
current market value. The balance of the PP&E account is re-measured every reporting period, and, after
accounting for historical cost and amortization, is called the book value. This figure is reported on the
balance sheet. While PP&E is generally meant to be held and used by the company in the course of its
business, it is considered an asset because a company could sell its property, plant or equipment, either
because it is no longer of use or if the company runs into financial difficulties. Of course, selling property,
plant and equipment that is necessary to a company's course of business could be drastic and could signal
that a company is in financial trouble. It is important to note, that whatever the reason a company has in
selling some of its property, plant or equipment, it is unlikely that a company will make a profit on the
sale of the asset.

Land is real estate or property, minus buildings and equipment that does not occur in a natural way. Land
ownership may offer the title holder the right to natural resources on the land. The traditional school of
economics dictates that land is a factor of production, along with capital and labor. The sale of land results
in capital gain or loss; under IRS tax laws, land is not a depreciable asset. The term land can be looked at
in a number of ways, and its definition viewed differently depending on the nature under which it is
analyzed. The basic concept of land is it is a piece of earth, namely a piece of property that has an owner.
A more delineated concept of land, the legal concept of land, is it is a factor of some form of production,
and though it is not consumed during this production, no production would be possible without it. Land
is, therefore, a resource with no cost of production. Despite the fact usages of land can be altered from
less to more profitable, supply cannot be increased. The term land is inclusive of all physical elements,
bestowed by nature, to a specific area or piece of property. This includes environment, fields, forests,
minerals, climate, animals and bodies or sources of water. In terms of being an asset, land includes

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anything that is on the ground, which means buildings, trees and water are a part of land as an asset.
Lenders are extremely attracted to land because it is one of the oldest form of collateral, and because it
cannot be moved, stolen, wasted or destroyed. Air and space rights are also covered by the term, meaning
all air and space above and below the property is part of the term. There is a wealth of natural resources
that may be present on a property or piece of land that the owner, or title holder, may be entitled to. This
includes plants, human and animal life, soil, minerals, geographical location, electromagnetic features and
geophysical occurrences. Depletion of various natural resources in the United States, specifically natural
gas and oil, is of great value and drilling and oil companies, in many instances, pay landowners substantial
sums of money for the privilege of using an owner's land to access such natural resources, as well as shell
out small fortunes for large acreages of access, specifically if the land is rich in a specific resource.

Investments: an investment is an asset or item that is purchased with the hope that it will generate
income or will appreciate in the future. In an economic sense, an investment is the purchase of goods that
are not consumed today but are used in the future to create wealth. In finance, an investment is a
monetary asset purchased with the idea that the asset will provide income in the future or will be sold at
a higher price for a profit. The term "investment" can be used to refer to any mechanism used for the
purpose of generating future income. In the financial sense, this includes the purchase of bonds, stocks
or real estate property. Additionally, the constructed building or other facility used to produce goods can
be seen as an investment. The production of goods required to produce other goods may also be seen as
investing. Taking an action in the hopes of raising future revenue can also be an investment. Choosing to
pursue additional education can be considered an investment, as the goal is to increase knowledge and
improve skills in the hopes of producing more income. Economic growth can be encouraged through the
use of sound investments at the business level. When a company constructs or acquires a new piece of
production equipment in order to raise the total output of goods within the facility, the increased
production can cause the nation’s gross national product (GDP) to rise. This allows the economy to grow
through increased production, based on the previous equipment investment.

Goodwill is an intangible asset that arises as a result of the acquisition of one company by another for a
premium value. The value of a company’s brand name, solid customer base, good customer relations,
good employee relations and any patents or proprietary technology represent goodwill. Goodwill is
considered an intangible asset because it is not a physical asset like buildings or equipment. The goodwill
account can be found in the assets portion of a company's balance sheet. The value of goodwill typically
arises in an acquisition when one company is purchased by another company. The amount the acquiring
company pays for the target company over the target’s book value usually accounts for the value of the
target’s goodwill. If the acquiring company pays less than the target’s book value, it gains “negative
goodwill,” meaning that it purchased the company at a bargain in a distress sale. Goodwill is difficult to
price, but it does make a company more valuable. Because the components that make up goodwill have
subjective values, there is a substantial risk that a company could overvalue goodwill in an acquisition.
This overvaluation would be bad news for shareholders of the acquiring company, since they would likely
see their share values drop when the company later has to write down goodwill.

Intangible assets are an asset that is not physical in nature. Corporate intellectual property, including
items such as patents, trademarks, copyrights and business methodologies, are intangible assets, as are
goodwill and brand recognition. Intangible assets exist in opposition to tangible assets which include land,
vehicles, equipment, inventory, stocks, bonds and cash. An intangible asset can be classified as either

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indefinite or definite. A company brand name is an indefinite asset, as it stays with the company as long
as the company continues operations. However, if a company enters a legal agreement to operate under
another company's patent, with no plans of extending the agreement, the agreement has a limited life
and is classified as a definite asset. While intangible assets don't have the obvious physical value of a
factory or equipment, they can prove valuable for a firm and can be critical to its long-term success or
failure. Although brand recognition is not a physical asset that can be seen or touched, its positive effects
on bottom-line profit are the driving force behind global sales year after year. Businesses may create or
acquire intangible assets. For example, a business may create a mailing list of clients or it may establish a
patent. However, another business may eventually buy or acquire either of those intangibles. If a business
creates an intangible asset, it cannot write off its value on its income tax return, but if a business acquires
the asset, it may claim the cost as a capital expense.

Deferred tax asset is an accounting term that refers to a situation where a business has overpaid taxes or
taxes paid in advance on its balance sheet. These taxes are eventually returned to the business in the form
of tax relief, and the over-payment is, therefore, an asset for the company. A deferred tax asset can
conceptually be compared to rent paid in advance or refundable insurance premiums; while the business
no longer has cash on hand, it does have comparable value, and this must be reflected in its financial
statements. Deferred tax assets are often created due to taxes paid or carried forward but not yet
recognized in the income statement. For example, deferred tax assets can be created due to the tax
authorities recognizing revenue or expenses at different times than that of an accounting standard. This
asset helps in reducing the company’s future tax liability. It is important to note that a deferred tax asset
is recognized only when the difference between the loss-value or depreciation of the asset is expected to
offset future profit. The simplest example of a deferred tax asset is the carry-over of losses. If a business
incurs a loss in a financial year, it usually is entitled to use that loss in order to lower its taxable income in
following years. In that sense, the loss is an asset. Another scenario where deferred tax assets arise is
where there is a difference between accounting rules and tax rules. For example, deferred taxes exist
when expenses are recognized in the income statement before they are required to be recognized by the
tax authorities or when revenue is subject to taxes before it is taxable in the income statement. Essentially,
whenever the tax base or tax rules for assets and/or liabilities are different, there is an opportunity for
the creation of a deferred tax asset. Income tax that is deferred because of discrepancies between a
company's tax return and the tax calculated on the company's financial statements. Future income tax
occurs when there is a greater amount of deductions on taxable income than on the net income that is
calculated on a company's income statement. In simple terms future income tax is an adjustment
accounting for the difference between what the company has already paid in taxes on the current income
and what they will have to pay in the future for this income. This difference occurs because companies
are taxed by government in a different way than from the way they calculate tax on their accounting
records.

Capital lease is a contract entitling a renter to a temporary use of an asset, and such a lease has economic
characteristics of asset ownership for accounting purposes. The capital lease requires a renter to add
assets and liabilities associated with the lease if the rental contract meets specific requirements. In
substance, a capital lease is considered a purchase of an asset, while an operating lease is handled as a
true lease under generally accepted accounting principles (GAAP). To qualify as a capital lease, a lease
contract must satisfy any of the four criteria. First, the life of the lease must be 75% or greater of the
asset's useful life. Second, the lease must contain a bargain purchase option for a price less than the

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market value of an asset. Third, the lessee must gain ownership at the end of the lease period. Finally, the
present value of lease payments must be greater than 90% of the asset's market value. A capital lease is
an example of accrual accounting's inclusion of economic events, which requires a company to calculate
the present value of capital lease payments on its financial statements. For instance, if a company
estimated the present value of its obligation under a capital lease to be $100,000, it then records a
$100,000 debit entry to the corresponding fixed asset account and a $100,000 credit entry to the capital
lease liability account on its balance sheet. Because a capital lease is a financing arrangement, a company
must break down its periodic lease payments into interest expense based on the company's applicable
interest rate and depreciation expense.

LIABILITIES
Liabilities are a company's financial debt or obligations that arise during the course of its business
operations. Liabilities are settled over time through the transfer of economic benefits including money,
goods or services. Recorded on the right side of the balance sheet, liabilities include loans, accounts
payable, mortgages, deferred revenues and accrued expenses. Liabilities are a vital aspect of a company
because they are used to finance operations and pay for large expansions. They can also make
transactions between businesses more efficient. Generally, liability refers to the state of being responsible
for something, and this term can refer to any money or service owed to another party. Liability may also
refer to the legal liability of a business or individual. Businesses sort their liabilities into two categories:
current and long-term. Current liabilities are debts payable within one year, while long-term liabilities are
debts payable over a longer period. Assets are the things a company owns, and they include tangible items
such as buildings, machinery, and equipment as well as intangible items such as accounts receivable,
patents or intellectual property. Liabilities are the things that a company owes. If a business subtracts its
liabilities from its assets, the difference is its owner's or stockholders' equity. This relationship can be
expressed as assets - liabilities = owner's equity. However, in most cases, this equation is commonly
presented as liabilities + equity = assets.

Accounts payable (AP) is an accounting entry that represents an entity's obligation to pay off a short-term
debt to its creditors. On many balance sheets, the accounts payable entry appears under the heading
current liabilities. Another common usage of AP refers to a business department or division that is
responsible for making payments owed by the company to suppliers and other creditors. Accounts
payable are debits that must be paid off within a given period to avoid default. For example, at the
corporate level, AP refers to short-term debt payments to suppliers. The payable is essentially a short-
term IOU from the business to the other business, who acts as a creditor.

Note payable is written documentation of money loaned or owed from one party to another. The loan’s
terms, repayment schedule, interest rate and payment information are included in the note. The
borrower, or maker, signs the note and gives it to the lender, or payee, as proof of the repayment
agreement. “Pay to the order of” is often used in promissory notes, designating to whom the loan is
repaid. The lender may choose to have the payments go to himself or to a third party to whom money is
owed.

Accrued liability is an expense that a business has incurred but has not yet paid. A company can accrue
liabilities for any number of obligations, and the accruals can be recorded as either short-term or long-
term liabilities on a company's balance sheet. Payroll taxes, including Social Security, Medicare and federal

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unemployment taxes are liabilities that can be accrued in preparation for payment before the taxes are
past due. Accrued liabilities infers a good or service has been received by the company but the benefit has
not yet been paid for yet. Although the cash flow has yet to occur, the company still maintains an
obligation to pay for the benefit received. Accrued liabilities only exist when using an accrual method of
accounting. The other alternative – the cash method – does not accrue liabilities. Accrued liabilities are
entered into the financial records during one period and are typically reversed in the next. This will allow
for the actual expense to be recorded at the accurate dollar amount when payment is made in full. The
concept of an accrued liability relates to timing and the matching principle. Under accrual accounting, all
expenses are to be recognized in the period in which they are incurred. These expenses are recorded in
the same period when related revenues are reported to provide financial statement users accurate
information regarding the costs required to generate income. Accrued liabilities arise due to events that
occur during the normal course of business. A company that purchased goods or services on a deferred
payment plan will accrue liabilities, because the obligation to pay is present. Employees may have
performed work but have not yet received payment. Interest on loans may be accrued if interest fees
have been incurred since the previous loan payment. Taxes owed to governments may be accrued
because they will not be due until the next tax reporting period.

Long-term debt consists of loans and financial obligations lasting over one year. Long-term debt for a
company would include any financing or leasing obligations that are to come due in a greater than 12-
month period. Long-term debt also applies to governments: nations can also have long-term debt.
Financial and leasing obligations, also called long-term liabilities, or fixed liabilities, would include
company bond issues or long-term leases that have been capitalized on a firm's balance sheet. Often, a
portion of these long-term liabilities must be paid within the year; these are categorized as current
liabilities, and are also documented on the balance sheet. The balance sheet can be used to track the
company's debt and profitability. On a balance sheet, the company's debts are categorized as either
financial liabilities or operating liabilities. Financial liabilities refer to debts owed to investors or
stockholders; these include bonds and notes payable. Operating liabilities refer to the leases or unsettled
payments incurred in order to maintain facilities and services for the company. These include everything
from rented building spaces and equipment to employee pension plans. Bonds are one of the most
common types of long-term debt. Companies may issuing bonds to raise funds for a variety of reasons.
Bond sales bring in immediate income, but the company ends up paying for the use of investors' capital
due to interest payments. A high debt to equity ratio means the company is funding most of its ventures
with debt. If this ratio is too high, the company is at risk of bankruptcy if it becomes unable to finance its
debt due to decreased income or cash flow problems. A high debt to equity ratio also tends to put a
company at a disadvantage against its competitors who may have more cash. Many industries discourage
companies from taking on too much long-term debt in order to reduce the risks and costs closely
associated with unstable forms of income, and they even pass regulations that restrict the amount of
long-term debt a company can acquire. A low debt to equity ratio is a sign that the company is growing or
thriving, as it is no longer relying on its debt and is making payments to lower it. It consequently has more
leverage with other companies and a better position in the current financial environment. However, the
company must also compare its ratio to those of its competitors, as this context helps determines
economic leverage.

Deferred tax liability is an account on a company's balance sheet that is a result of temporary differences
between the company's accounting and tax carrying values, the anticipated and enacted income tax rate,

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and estimated taxes payable for the current year. This liability may be realized during any given year,
which makes the deferred status appropriate. Because there are differences between what a company
can deduct for tax and accounting purposes, there is a difference between a company's taxable income
and income before tax. A deferred tax liability records the fact the company will, in the future, pay more
income tax because of a transaction that took place during the current period, such as an installment sale
receivable. Because U.S. tax laws and accounting rules differ, a company's earnings before taxes on the
income statement can be greater than its taxable income on a tax return, giving rise to a deferred tax
liability on the company's balance sheet . The deferred tax liability represents a future tax payment a
company is expected to make to appropriate tax authorities in the future, and it is calculated as the
company's anticipated tax rate times the difference between its taxable income and accounting earnings
before taxes. A common source of deferred tax liability is the difference in depreciation expense
treatment by tax laws and accounting rules. The depreciation expense for long-lived assets for financial
statements purposes is typically calculated using a straight-line method, while tax regulations allow
companies to use an accelerated depreciation method. Since the straight-line method produces lower
depreciation when compared to that of the under-accelerated method, a company's accounting income
is temporarily higher than its taxable income. The company recognizes the deferred tax liability on the
differential between its accounting earnings before taxes and taxable income. As the company continues
depreciating its assets, the difference between straight-line depreciation and accelerated depreciation
narrows, and the amount of deferred tax liability is gradually removed through a series of offsetting
accounting entries. Another common source of deferred tax liability is an installment sale, which is the
revenue recognized when a company sells its products on credit to be paid off in equal amounts in the
future. Under accounting rules, the company is allowed to recognize full income from the installment sale
of general merchandise, while tax laws require companies to recognize the income when installment
payments are made. This creates a temporary positive difference between the company's accounting
earnings and taxable income, as well as a deferred tax liability. . Income tax that is deferred because of
discrepancies between a company's tax return and the tax calculated on the company's financial
statements. Future income tax occurs when there is a greater amount of deductions on taxable income
than on the net income that is calculated on a company's income statement. In simple terms future
income tax is an adjustment accounting for the difference between what the company has already paid
in taxes on the current income and what they will have to pay in the future for this income. This difference
occurs because companies are taxed by government in a different way than from the way they calculate
tax on their accounting records.

Deferred revenue, or unearned revenue, refers to advance payments for products or services that are to
be delivered in the future. The recipient of such prepayment records unearned revenue as a liability on a
balance sheet, because it refers to revenue that has not yet been earned, but represents products or
services that are owed to a customer. As the product or service is delivered over time, it is recognized as
revenue on the income statement. Deferred revenue is recognized as an obligation on the balance sheet
of a company that receives advance payment, because it owes its customers services or products.
Deferred revenue is most common among companies selling subscription-based products or services that
require prepayments. Examples of unearned revenue are rent payments made in advance, prepayment
for newspapers subscriptions, annual prepayment for the use of software, and prepaid insurance. As a
company delivers services or products, deferred revenue is gradually recognized on the income
statement. Analysts typically conduct a careful study of trends in deferred revenue accounts of companies
with significant unearned revenues balances, to obtain a better indication of their financial performance.

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Recording unearned revenues on an income statement, rather than as deferred revenues on the balance
sheet, may be considered as aggressive accounting, as it would have the effect of overstating revenues.
Deferred revenue is typically disclosed as a current liability on a company's balance sheet. However, if a
customer made an up-front prepayment for services that are expected to be delivered over several years,
the portion of the payment that pertains to services or products to be provided after 12 months from
payment date must be classified as deferred revenue under the long-term liability section of the balance
sheet.

SHAREHOLDERS EQUITY
Stockholders' equity is the portion of the balance sheet that represents the capital received from
investors in exchange for stock (paid-in capital), donated capital and retained earnings. Stockholders'
equity represents the equity stake currently held on the books by a firm's equity investors. It is calculated
either as a firm's total assets minus its total liabilities or as share capital plus retained earnings minus
treasury shares. Stockholders' equity is often referred to as the book value of the company, and it comes
from two main sources. The first and original source is the money that was originally invested in the
company, along with any additional investments made thereafter. The second comes from retained
earnings that the company is able to accumulate over time through its operations. In most cases,
especially when dealing with older companies that have been in business for many years, the retained
earnings portion is the largest component.

Common stock is a security that represents ownership in a corporation. Holders of common stock exercise
control by electing a board of directors and voting on corporate policy. Common stockholders are on the
bottom of the priority ladder for ownership structure; in the event of liquidation, common shareholders
have rights to a company's assets only after bondholders, preferred shareholders and other debtholders
are paid in full. If a company goes bankrupt, the common stockholders do not receive their money until
the creditors and preferred shareholders have received their respective share of the leftover assets. This
makes common stock riskier than debt or preferred shares. The upside to common shares is they usually
outperform bonds and preferred shares in the long run. Many companies issue all three types of
securities. For a company to issue stock, it must begin by having an initial public offering. An IPO is a great
way for a company seeking additional capital to expand. To begin the IPO process, a company must work
with an underwriting investment banking firm, which helps determine both the type and pricing of the
stock. After the IPO phase is completed, the general public is allowed to purchase the new stock on the
secondary market.

Additional Paid in Capital: Companies fund their asset purchases with equity capital, namely stockholders'
equity, and borrowed capital from issuing debt and incurring other liabilities. The equity capital or
stockholders' equity can also be viewed as a company's net assets — that is, total assets minus total
liabilities, the amount of monetary interest that belong to the company's owners or stockholders.
Investors originally and maybe later again contribute their share of capital as stockholders, and the capital
so contributed is called paid-in capital, which is the basic source of total stockholders' equity. The amount
of paid-in capital from each investor determines an investor's stockholder ownership percentage.

Preferred stock is a class of ownership in a corporation that has a higher claim on its assets and earnings
than common stock. Preferred shares generally have a dividend that must be paid out before dividends
to common shareholders, and the shares usually do not carry voting rights. Preferred stock combines

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features of debt, in that it pays fixed dividends, and equity, in that it has the potential to appreciate in
price. The details of each preferred stock depend on the issue. Preferred shareholders have priority over
common stockholders when it comes to dividends, which generally yield more than common stock and
can be paid monthly or quarterly. These dividends can be fixed or set in terms of a benchmark interest
rate like the LIBOR. Adjustable-rate shares specify certain factors that influence the dividend yield, and
participating shares can pay additional dividends that are reckoned in terms of common stock dividends
or the company's profits. If a company is struggling and has to suspend its dividend, preferred
shareholders may have the right to receive payment in arrears before the dividend can be resumed for
common shareholders. Shares that have this arrangement are known as cumulative. If a company has
multiple simultaneous issues of preferred stock, these may in turn be ranked in terms of priority: the
highest ranking is called prior, followed by first preference, second preference, etc. Preferred
shareholders have prior claim on a company's assets if it is liquidated, though they remain subordinate to
bondholders. Preferred shares are equity, but in many ways they are hybrid assets that lie between stock
and bonds. They offer more predicable income than common stock and are rated by the major credit
rating agencies. Unlike with bondholders, failing to pay a dividend to preferred shareholders does not
mean a company is in default. Because preferred shareholders do not enjoy the same guarantees as
creditors, the ratings on preferred shares are generally lower than the same issuer's bonds, with the yields
being accordingly higher. Preferred shares usually do not carry voting rights, although under some
agreements these rights may revert to shareholders that have not received their dividend. Some preferred
stock is convertible, meaning it can be exchanged for a given number of common shares under certain
circumstances. The board of directors might vote to convert the stock, the investor might have the option
to convert, or the stock might have a specified date at which it automatically converts.

Retained earnings are a company's net income from operations and other business activities, available to
stockholders and retained by the company as additional equity capital. Retained earnings are thus part of
stockholders' equity. They are actually returns on total stockholders' equity but reinvested back to the
company. Retained earnings are accumulated and grow larger over time as a company retains a portion
of its earnings after dividends each year. At some point, the amount of accumulated retained earnings is
to exceed the amount of equity capital contributed by stockholders and can eventually grow to be the
main source of stockholders' equity.

Treasury Stock: companies may return some capital out of its stockholders' equity back to stockholders
from time to time when management is not able to deploy all the available equity capital in ways that can
potentially deliver the best returns. This reverse capital exchange between a company and its stockholders
is known as share buybacks. Shares bought back by companies become treasury shares, and their dollar
value is noted in an account called treasury stock, a contra account to the accounts of paid-in capital and
retained earnings. Treasury shares can be reissued back to stockholders for purchases when companies
need to raise more capital.

Accumulated other comprehensive income (OCI) is a line item in the shareholders' equity section of the
balance sheet that includes income that is not reported in the income statement. Other comprehensive
income includes unrealized gains and losses on certain types of investments, as well as gains or losses on
pension funds and foreign currency transactions. OCI is excluded from net income, because the
transactions are unusual and are not generated through a company's normal business operations. In
addition to investment and pension plan gains and losses, OCI includes hedging transactions a company

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performs to limit losses. By segregating OCI transactions from operating income, a financial statement
reader can compare income between years and have more clarity about the sources of income. An
investment must have a buy and a sell transaction to realize a gain or a loss. An unrealized gain or loss
means that no sale transaction has occurred. OCI reports unrealized gains and losses for certain
investments based on the fair value of the security. Companies have several types of obligations for
funding a pension plan. Some of the income and loss activity for pension plans is reported in OCI. A defined
benefit plan, for example, requires the employer to plan for specific payments to retirees in future years.
If the assets invested in the plan are not sufficient, the company's pension plan liability increases. A firm's
liability for pension plans increases when the investment portfolio recognizes losses. Retirement plan
expenses and unrealized losses may be reported in OCI. Once the gain or loss is realized, the amount is
reclassified from OCI to net income. Investors reviewing a company's balance sheet can use the OCI
account as a barometer for upcoming threats or windfalls to net income. A multinational company that
must deal with different currencies may require a company to hedge against currency fluctuations, and
the unrealized gains and losses for those holdings are posted to OCI.

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Prepared by Joseph P. Mathew: KFUPM ACCT 502