What is a liability?
A liability is something a person or company owes, usually a sum of money. Liabilities are settled over time by transferring economic benefits, including money, goods, or services. On the right side of the balance sheet, liabilities include loans, accounts payable, mortgages, deferred revenues, bonds, warranties, and accrued expenses. Liabilities can be contrasted with assets. Liabilities refer to things you owe or have borrowed; assets are things you own or are owed. How Liabilities Work Generally, a liability is an obligation between one party and another that has not yet been completed or paid for. In accounting, a financial liability is also an obligation. Still, it is more defined by previous business transactions, events, sales, exchange of assets or services, or anything that would provide economic benefit at a later date. Current liabilities are usually considered short-term (expected to be concluded in 12 months or less), and noncurrent liabilities are long-term (12 months or greater). Liabilities are categorized as current or noncurrent, depending on their temporality. They can include a future service owed to others (short- or long-term borrowing from banks, individuals, or other entities) or a previous transaction that has created an unsettled obligation. The most common liabilities are usually the largest, like accounts payable and bonds payable. Most companies will have these two line items on their balance sheet, as they are part of ongoing current and long-term operations.
A company’s liabilities are vital because they are used to finance operations and pay for significant expansions. They can also make transactions between businesses more efficient. For example, in most cases, if a wine supplier sells a case of wine to a restaurant, it does not demand payment when it delivers the goods. Instead, it invoices the restaurant for the purchase to streamline the drop-off and make paying more accessible for the restaurant. The outstanding money the restaurant owes to its wine supplier is a liability.
In contrast, the wine supplier considers the money it is owed to be an asset. 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, or state. Liability can also refer to one’s potential damages in a civil lawsuit.
Types of Liabilities Businesses sort their liabilities into current and long-term. Current liabilities are debts payable within one year, while long-term liabilities are debts payable over a more extended period. For example, if a business takes out a mortgage payable over 15 years, that is a long-term liability. However, the mortgage payments 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. Current (Near-Term) Liabilities Ideally, analysts want to see that a company can pay current liabilities due within a year with cash.
Some short-term liabilities include payroll expenses and accounts payable, which include money owed to vendors, monthly utilities, and similar expenses. Other examples include wages payable and the total 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, like individuals, often use credit to purchase goods and services to finance over short periods of time. This represents the interest on those short-term credit purchases to be paid. Dividends Payable: For companies that have issued stock to investors and paid 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 a year until the dividend is paid. Unearned Revenues: A company’s liability to deliver goods and services at a future date after being paid in advance. This amount will be reduced 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 must account for the financial impact of an operation, division, or entity currently being held for sale or recently sold. This also includes the financial impact of a product line that has recently been shut down.
Noncurrent (Long-Term) Liabilities Considering the name, it’s pretty evident that any liability that is not near-term falls under noncurrent liabilities, which are expected to be paid in 12 months or more. Referring to the AT&T example, there are more items than your gardening variety company, which may list one or two items. Long-term debt, or bonds payable, is usually the most significant liability and is at the top. Companies of all sizes finance part of their ongoing long-term operations by issuing bonds, essentially loans from each party that purchases the bonds. This line item is in constant flux as bonds are issued, matured, or called back by the issuer. 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. Other examples include: Warranty Liability: Some liabilities are not as exact as AP and must be estimated based on the estimated amount of time and money spent repairing products under a warranty agreement. This is a joint 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. Deferred Credits: This broad category may be recorded as current or noncurrent, depending on the specifics of the transactions. These credits are revenue collected before it is recorded as earned 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 member may receive upon retirement, carried as a long-term liability as they accrue. In the AT&T example, this constitutes one-half of the total noncurrent total, second only to long-term debt. This liability is not overlooked with rapidly rising healthcare costs and deferred compensation. Unamortized Investment Tax Credits (UITC): This represents the difference between an asset’s historical cost and the depreciated amount. The then-amortized portion is a liability, but it is only the asset’s estimate of its fair market value. For an analyst, this details how aggressive or conservative a company is with its depreciation methods.
Liabilities vs. 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. Suppose a business subtracts its liabilities from its owner’s or stockholders’ equity. This relationship can be exAssets−Liabilities=Owner’s Assets−Liabilities=Owner’s Equity. However, in most cases, this accounting equation is commonly presented as follows: Assets = liabilities + equity. Assets, liabilities, and equity. Liabilities vs. Expenses An expense is the cost of operations a company incurs to generate revenue. Unlike assets and liabilities, expenses are related to the company, and both are listed on the 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 had 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. Liabilities are listed on a company’s balance sheet. The other is listed on the company’s income statement. These are the costs of a company’s operation. At the same time, liabilities are the obligations and debts a company owes. Expenses can be paid immediately with cash, or the payment could be delayed, creating a liability. Example of Liabilities As a firm example of a firm’s liabilities, let’s use a historical example using AT&T’s (T) 2020 balance sheet. 1 The current and short-term liabilities are separated from the long-term and noncurrent liabilities on the balance sheet. AT&T defines its bank debt as maturing under current liabilities 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 more oversized items, which would be better suited to using long-term debt. Like most assets, liabilities are carried at cost, not market value, and under generally accepted accounting principles (GAAP) rules, they 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 and taxes will have higher current debt obligations. 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.
How Do I Know If Something Is a Liability?
A liability is borrowed from, owed to, or obligated to someone else. It can be absolute (e.g., a bill that needs to be paid) or potential (e.g., a possible lawsuit). A liability is not necessarily a bad thing. For instance, a company may take out debt (a liability) to expand and grow its business. Or, an individual may take out a mortgage to purchase a home. How Are Current Liabilities Different From Long-Term (Noncurrent) Ones? Companies will segregate their liabilities by time horizon for when they are due.
Current assets frequently cover current liabilities, which are due within a year. Noncurrent liabilities are due over the course of a year, often including debt repayments and deferred payments.
How do liabilities relate to assets and equity?
The accounting equation states that assets = liabilities + equity. As a result, we can re-arrange the firm’s liabilities as assets minus equity. Thus, the value of a firm’s total liabilities is the shareholder’s difference between the values of total assets and shareholders’ equity. If a firm takes on more liabilities without accumulating additional assets, it must reduce the value of the firm’s equity position. What is contingent liability? A contingent liability is an obligation that might have to be paid in the future. However, unresolved matters still 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.
What are examples of individuals?
Like businesses, an individual’s or household’s net worth is determined 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. The work owed may also be a liability if you are pre-paid for performing work or a service.
Conclusion
- Most of the time, a debt is something that you owe someone else.
- Liability can also mean an obligation or risk under the law or rules.
- In accounting, companies record their debts before their assets.
- Current liabilities are a company’s short-term debts due within a year or a usual business period. Examples of current liabilities are accounts payable.
- On the balance sheet, long-term (noncurrent) liabilities are not due for more than a year.
