What Is a Liability?
A liability is something a person or company owes, usually a sum of money. 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, bonds, warranties, and accrued expenses.
Liabilities can be contrasted with assets. Liabilities refer to things that you owe or have borrowed; assets are things that you own or are owed.
- A liability (generally speaking) is something that is owed to somebody else.
- Liability can also mean a legal or regulatory risk or obligation.
- In 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 a normal operating cycle (e.g. accounts payable).
- Long-term (non-current) liabilities are obligations listed on the balance sheet not due for more than a year.
How Liabilities Work
In general, a liability is an obligation between one party and another not yet completed or paid for. In the world of accounting, a financial liability is also an obligation but 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 consideredshort-term(expected to be concluded in 12 months or less) and non-current liabilities are long-term (12 months or greater).
Liabilities are categorized as current or non-current 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 likeaccounts payableand 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.
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. 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. Rather, it invoices the restaurant for the purchase to streamline the drop-off and make paying easier for the restaurant.
The outstanding money that the restaurant owes to its wine supplier is considered a liability. In contrast, the wine supplier considers the money it is owed to be an asset.
Liability may also refer to the legal liability of a business or individual. For example, many businesses take out liability insurance in case a customer or employee sues them for negligence.
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.
Liability can also refer to one's potential damages in a civil lawsuit.
Types of 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.
Current (Near-Term) Liabilities
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. Other examples include:
- Wages Payable:The total amount ofaccrued incomeemployees 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 haveissued stock to investors and pay a dividend, this represents the amount owed to shareholders after thedividend was declared. This period is aroundtwo weeks, so this liability usually pops upfour times per year, until the dividend is paid.
- 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 aproduct linethat is or has recently been shut down.
Non-Current (Long-Term) Liabilities
Considering the name, it’s quite obvious that any liability that is not near-term 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 byissuing bonds that are essentially loansfrom each party that purchases the bonds. This line item is in constant flux as bonds are issued, mature, or called back by theissuer.
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 have to be estimated. It’s the estimated amount of time and money that may be spent repairing products upon the agreement of awarranty. 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 aliabilitythat may occur depending on the outcome of an uncertain future event.
- 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 before it is recorded as earned on the income statement. It may include customer advances,deferred revenue,or a transactionwhere 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 itaccrues. In the AT&T example, this constitutes one-halfof the total non-current total second only to long-term debt. With rapidly rising health care anddeferred compensation, this liability is not to be overlooked.
- Unamortized Investment Tax Credits (UITC):This represents the net between an asset'shistorical costand the amount that has already been depreciated. The unamortized portion is a liability, but it is only a rough estimate of the asset’sfair market value. For ananalyst, this provides some details of how aggressive or conservative a company is with itsdepreciationmethods.
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.
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:
Liabilities vs. Expenses
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 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. One—the liabilities—are 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.
Example of Liabilities
As a practical example of understanding a firm's liabilities, let's look at a historical example using AT&T's (T) 2020 balance sheet. The current/short-term liabilities are separated from long-term/non-current liabilities on the balance sheet.
AT&T clearly defines its bank debt that is maturing in less than one year under current liabilities. 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 usinglong-term debt.
Like most assets, liabilities are carried at cost, notmarket value, and undergenerally accepted accounting principle (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 likepayroll, taxes will be higher current debt obligations.
APtypically 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 nopromissory noteis 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 something that is borrowed from, 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).
A liability is not necessarily a bad thing. For instance, a company may take out debt (a liability) in order 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 their time horizon for when they are due. Current liabilities are due within a year and are often paid for using current assets. Non-current liabilities are due in more than one year and most often include 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 formula to read liabilities = assets - equity. Thus, the value of a firm's total liabilities will equal the difference between 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.
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.
As an expert in finance and accounting, with a deep understanding of the concepts and principles outlined in the provided article, I can discuss the intricacies of liabilities and their significance in various contexts. Let's break down the key components and concepts mentioned in the article:
Liability Definition and Types:
- A liability represents an obligation to transfer economic benefits, typically money, goods, or services, to another party. Liabilities can be current (due within a year) or non-current (due in more than a year).
- Examples of liabilities include loans, accounts payable, mortgages, deferred revenues, bonds, warranties, and accrued expenses.
Current vs. Non-Current Liabilities:
- Current liabilities are short-term obligations due within one year or the normal operating cycle. Examples include accounts payable, wages payable, interest payable, and dividends payable.
- Non-current liabilities are long-term obligations due in more than one year. Examples include long-term debt, warranty liabilities, contingent liabilities, and deferred credits.
Significance of Liabilities:
- Liabilities play a vital role in financing operations and facilitating transactions between businesses. They are essential for understanding a company's financial health and its ability to meet short-term and long-term obligations.
Liabilities in Accounting and Financial Reporting:
- Liabilities are recorded on the right side of the balance sheet, opposite assets. The accounting equation states that Assets = Liabilities + Equity.
- Liabilities are essential for calculating a company's leverage and its ability to generate returns for shareholders.
Liabilities vs. Assets and Equity:
- Assets represent what a company owns, while liabilities represent what it owes. The difference between assets and liabilities is equity, which represents the owners' stake in the company.
- The relationship between assets, liabilities, and equity is fundamental to understanding a company's financial position.
- Contingent liabilities are potential obligations that may arise from uncertain future events, such as lawsuits, warranties, or product recalls. They are disclosed in financial statements but are not recognized as actual liabilities until they materialize.
Liabilities in Personal Finance:
- Individuals and households also have liabilities, including taxes, bills, mortgage payments, loan obligations, and prepaid services or work.
Understanding liabilities is crucial for investors, analysts, business owners, and individuals alike, as they provide insight into financial obligations and risk exposures. Whether analyzing corporate balance sheets or managing personal finances, a clear understanding of liabilities is essential for making informed decisions and assessing financial health.