Liability Definition





What is Liability?

 

 liability is defined as the future sacrifices of economic benefits that the entity is obliged to make to other entities as a result of past transactions or other past events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future.

 

  • A liability, generally speaking, is something that is owed to somebody else.

  • A liability can also mean a legal or regulatory risk or obligation.

  • In corporate accounting, companies book liabilities in opposition to assets.

  • Current liabilities are a company’s short-term financial obligations that are due within one year or within a normal operating cycle such as accounts payable and taxes owed.

  • Long-term (noncurrent) liabilities are obligations listed on the balance sheet not due for more than a year such as bond interest payments.

 

A liability is defined by the following characteristics:

 

Any type of borrowing from persons or banks for improving a business or personal income that is payable during short or long time;

A duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services, or other transaction yielding an economic benefit, at a specified or determinable date, on occurrence of a specified event, or on demand;

A duty or responsibility that obligates the entity to another, leaving it little or no discretion to avoid settlement; and,

A transaction or event obligating the entity that has already occurred

Liabilities in financial accounting need not be legally enforceable; but can be based on equitable obligations or constructive obligations. An equitable obligation is a duty based on ethical or moral considerations. A constructive obligation is an obligation that is implied by a set of circumstances in a particular situation, as opposed to a contractually based obligation.

 

The accounting equation relates assets, liabilities, and owner’s equity:

 

Assets = Liabilities + Owner’s Equity

The accounting equation is the mathematical structure of the balance sheet.

 

Probably the most accepted accounting definition of liability is the one used by the International Accounting Standards Board (IASB). The following is a quotation from IFRS Framework:

 

A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits

— F.49(b)

 

Regulations as to the recognition of liabilities are different all over the world, but are roughly similar to those of the IASB.

 

Examples of types of liabilities include: money owing on a loan, money owing on a mortgage, or an IOU.

 

Liabilities are debts and obligations of the business they represent as creditor’s claim on business assets.

 

Liabilities Example

 

When a company deposits cash with a bank, the bank records a liability on its balance sheet, representing the obligation to repay the depositor, usually on demand. Simultaneously, in accordance with the double-entry principle, the bank records the cash, itself, as an asset. The company, on the other hand, upon depositing the cash with the bank, records a decrease in its cash and a corresponding increase in its bank deposits (an asset).

 

Debits and Credits

 

A debit either increases an asset or decreases a liability; a credit either decreases an asset or increases a liability. According to the principle of double-entry, every financial transaction corresponds to both a debit and a credit.

 

Example

 

When cash is deposited in a bank, the bank is said to “debit” its cash account, on the asset side, and “credit” its deposits account, on the liabilities side. In this case, the bank is debiting an asset and crediting a liability, which means that both increase.

 

When cash is withdrawn from a bank, the opposite happens: the bank “credits” its cash account and “debits” its deposits account. In this case, the bank is crediting an asset and debiting a liability, which means that both decrease.

 

Other Definitions of Liability

 

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. Tax liability, for example, can refer to the property taxes that a homeowner owes to the municipal government or the income tax he owes to the federal government. When a retailer collects sales tax from a customer, they have a sales tax liability on their books until they remit those funds to the county/city/state.

 

Current Versus Long-Term Liabilities

 

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. For example, if a business takes out a mortgage payable over a 15-year period, that is a long-term liability. However, the mortgage payments that are due during the current year are considered the current portion of long-term debt and are recorded in the short-term liabilities section of the balance sheet.

 

Ideally, analysts want to see that a company can pay current liabilities, which are due within a year, with cash. Some examples of short-term liabilities include payroll expenses and accounts payable, which include money owed to vendors, monthly utilities, and similar expenses. In contrast, analysts want to see that long-term liabilities can be paid with assets derived from future earnings or financing transactions. Bonds and loans are not the only long-term liabilities companies incur. Items like rent, deferred taxes, payroll, and pension obligations can also be listed under long-term liabilities.

 

The Relationship Between Liabilities and Assets

 

Assets are the things a company owns—or things owed to the company—and they include tangible items such as buildings, machinery, and equipment as well as intangible items such as accounts receivable, interest owed, patents, or intellectual property.

 

If a business subtracts its liabilities from its assets, the difference is its owner’s or stockholders’ equity. This relationship can be expressed as follows:

 

However, in most cases, this accounting equation is commonly presented as such:

 

{Assets} = {Liabilities} + {Equity}Assets=Liabilities+Equity

 

What Is the Difference Between an Expense and a Liability?

An expense is the cost of operations that a company incurs to generate revenue. Unlike assets and liabilities, expenses are related to revenue, and both are listed on a company’s income statement. In short, expenses are used to calculate net income. The equation to calculate net income is revenues minus expenses.

 

For example, if a company has more expenses than revenues for the past three years, it may signal weak financial stability because it has been losing money for those years.

 

Expenses and liabilities should not be confused with each other. One is listed on a company’s balance sheet, and the other is listed on the company’s income statement. Expenses are the costs of a company’s operation, while liabilities are the obligations and debts a company owes. Expenses can be paid immediately with cash, or the payment could be delayed which would create a liability.

 

Examples of Liabilities

 

As a practical example of understanding a firm’s liabilities, let’s look at a historical example using AT&T’s (NYSE: T) 2012 balance sheet.1

 

 

Current Liabilities

 

Using the AT&T (NYSE:T) balance sheet as of Dec. 31, 2012, current/short-term liabilities are segregated from long-term/non-current liabilities on the balance sheet. AT&T clearly defines its bank debt maturing in less than one year. For a company this size, this is often used as operating capital for day-to-day operations rather than funding larger items, which would be better suited using long-term debt.

 

Like most assets, liabilities are carried at cost, not market value, and under GAAP rules can be listed in order of preference as long as they are categorized. The AT&T example has a relatively high debt level under current liabilities. With smaller companies, other line items like accounts payable (AP) and various future liabilities like payroll, taxes, and ongoing expenses for an active company carry a higher proportion.

 

AP typically carries the largest balances, as they encompass the day-to-day operations. AP can include services, raw materials, office supplies, or any other categories of products and services where no promissory note is issued. Since most companies do not pay for goods and services as they are acquired, AP is equivalent to a stack of bills waiting to be paid.

 

Examples of Common Current Liabilities

 

Wages Payable: The total amount of accrued income employees have earned but not yet received. Since most companies pay their employees every two weeks, this liability changes often.

Interest Payable: Companies, just like individuals, often use credit to purchase goods and services to finance over short time periods. This represents the interest on those short-term credit purchases to be paid.

Dividends Payable: For companies that have issued stock to investors and pay a dividend, this represents the amount owed to shareholders after the dividend was declared. This period is around two weeks, so this liability usually pops up four times per year, until the dividend is paid.

Less Common Current Liabilities

Unearned Revenues: This is a company’s liability to deliver goods and/or services at a future date after being paid in advance. This amount will be reduced in the future with an offsetting entry once the product or service is delivered.

Liabilities of Discontinued Operations: This is a unique liability that most people glance over but should scrutinize more closely. Companies are required to account for the financial impact of an operation, division, or entity that is currently being held for sale or has been recently sold. This also includes the financial impact of a product line that is or has recently been shut down.

Since most companies do not report line items for individual entities or products, this entry points out the implications in aggregate. As there are estimates used in some of the calculations, this can carry significant weight.

 

A good example is a large technology company that has released what it considered to be a world-changing product line, only to see it flop when it hit the market. All the R&D, marketing, and product release costs need to be accounted for under this section.

 

Non-Current Liabilities

 

Considering the name, it’s quite obvious that any liability that is not current falls under non-current liabilities expected to be paid in 12 months or more. Referring again to the AT&T example, there are more items than your garden variety company that may list one or two items. Long-term debt, also known as bonds payable, is usually the largest liability and at the top of the list.

 

Companies of all sizes finance part of their ongoing long-term operations by issuing bonds that are essentially loans from each party that purchases the bonds. This line item is in constant flux as bonds are issued, mature, or called back by the issuer.

 

Example of Common Non-Current Liabilities

Warranty Liability: Some liabilities are not as exact as AP and have to be estimated. It’s the estimated amount of time and money that may be spent repairing products upon the agreement of a warranty. This is a common liability in the automotive industry, as most cars have long-term warranties that can be costly.

Contingent Liability Evaluation: A contingent liability is a liability that may occur depending on the outcome of an uncertain future event.

Less Common Non-Current Liabilities

 

Deferred Credits: This is a broad category that may be recorded as current or non-current depending on the specifics of the transactions. These credits are basically revenue collected prior to it being earned and recorded on the income statement. It may include customer advances, deferred revenue, or a transaction where credits are owed but not yet considered revenue. Once the revenue is no longer deferred, this item is reduced by the amount earned and becomes part of the company’s revenue stream.

Post-Employment Benefits: These are benefits an employee or family members may receive upon his/her retirement, which are carried as a long-term liability as it accrues. In the AT&T example, this constitutes one-half of the total non-current total second only to long-term debt. With rapidly rising health care and deferred compensation, this liability is not to be overlooked.

Unamortized Investment Tax Credits (UITC): This represents the net between an asset’s historical cost and the amount that has already been depreciated. The unamortized portion is a liability, but it is only a rough estimate of the asset’s fair market value. For an analyst, this provides some details of how aggressive or conservative a company is with its depreciation methods.

Frequently Asked Questions

How do I know if something is a liability?

A liability is something that is owed to or obligated to someone else. It can be real (e.g. a bill that needs to be paid) or potential (e.g. a possible lawsuit).

 

How are current liabilities different from long-term (noncurrent) ones?

Companies will segregate their liabilities by their time horizon for when they are due. Current liabilities are due with a year and are often paid for using current assets. Noncurrent liabilities are due in more than one-year and most often include debt repayments and deferred payments. Most companies will have these two line items on their balance sheet, as they are part of ongoing current and long-term operations.

 

How do liabilities relate to assets and equity?

The accounting equation states that assets = liabilities + equity. As a result, we can re-arrange the formula to read liabilities = assets – equity. Thus, the value of a firm’s total liabilities will equal the difference of the values of total assets and shareholders’ equity. If a firm takes on more liabilities without accumulating additional assets, it must result in a reduction in the value of the firm’s equity position.

 

What is a contingent liability?

A contingent liability is an obligation that might have to be paid in the future, but there are still unresolved matters that make it only a possibility and not a certainty. Lawsuits and the threat of lawsuits are the most common contingent liabilities, but unused gift cards, product warranties, and recalls also fit into this category. Contingent liabilities must be listed on a company’s balance sheet if they are both probable and the amount can be estimated.

 

What are examples of liabilities that individuals or households have?

Like businesses, an individual’s or household’s net worth is taken by balancing assets against liabilities. For most households, liabilities will include taxes due, bills that must be paid, rent or mortgage payments, loan interest and principal due, and so on. If you are pre-paid for performing work or a service, the work owed may also be construed as a liability.

 

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