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Liability

A legal obligation of a company

What is a Liability?

A liability is a financial obligation of a company that results in the company’s future sacrifices of the economic benefits to other entities or businesses. A liability can be an alternative to equity as a source of a company’s financing. Moreover, some liabilities such as accounts payable or income taxes payable are essential parts of day-to-day business operations.

 

Liability

 

Liabilities can help the companies organize successful business operations and accelerate value creation. However, poor management of the liabilities may result in significant negative consequences such as a decline in financial performance or worse, bankruptcy.

In addition, the liabilities determine the company’s liquidity and capital structure.

 

Accounting Reporting of Liabilities

A company reports its liabilities on a balance sheet. According to the accounting equation, the total amount of the liabilities must be equal to the difference between the total amount of the assets and the total amount of the equity.

Assets = Liabilities + Equity

Liabilities = Assets – Equity

 

Liabilities must be reported according to the accepted accounting principles. The most common accounting standards are the International Financial Reporting Standards (IFRS). The standards are adopted by many countries around the world. However, many countries also follow their own reporting standards such as the GAAP in the U.S. or the RAP in Russia. Although the recognition and reporting of the liabilities comply with different accounting standards, the main principles are close to the IFRS.

On a balance sheet, liabilities are listed according to the time when the obligation is due.

 

Current Liabilities vs. Long-term Liabilities

The primary classification of liabilities is according to their due date. The classification is critical to the company’s management for a proper control of the financial obligations.

Current liabilities are the liabilities that are due within a year. This type of the liabilities is primarily used in regular business operations. Due to the short-term nature of the financial obligations, current liabilities should be managed with consideration of the company’s liquidity. Liquidity is frequently determined as a ratio between current assets and current liabilities. The most common current assets are:

  • Accounts payable: They are the unpaid bills to the company’s vendors. Generally, accounts payable are the largest current assets for most businesses.
  • Interest payable: Interest expenses that have already occurred but have not been paid. Interest payable should not be confused with the interest expenses. Unlike interest payable, interest expenses are expenses that have already incurred and have already been paid. Therefore, interest expenses are reported on the income statement, while interests payable are recorded on the balance sheet.
  • Income taxes payable: The income tax amount owed by a company to the government. The tax amount owed must be payable within one year. Otherwise, the tax owed must be classified as a long-term liability.
  • Bank account overdrafts: A type of short-term loan provided by a bank when the payment is processed with no sufficient funds available in the bank account.
  • Accrued expenses: Expenses that have incurred but no supporting documentation (e.g., invoice) has been received or issued.
  • Short-term loans: Loans with a maturity of one year or less.

 

Long-term (non-current) liabilities are the liabilities that are due after more than one year. It is important that the long-term liabilities exclude the amounts that are due in the short-term, such as interest payable, which are current liabilities.

Long-term liabilities can be a source of financing, as well as refer to amounts that arise from business operations. For example, bonds or mortgage can be used to finance the company’s projects that require a large amount of financing. At the same time, the deferred tax payable or capital leases arise from the specifications of the business operations.  The liabilities are critical to the understanding of the overall liquidity and capital structure of a company.

 

Long-term liabilities include:

  • Bonds payable: The amount of outstanding bonds with a maturity of over one year issued by a company. On a balance sheet, the bonds payable account indicates the face value of the company’s outstanding bonds.
  • Notes payable: The amount of promissory notes with a maturity of over one year issued by a company. Similar to bonds payable, the notes payable account on a balance sheet indicates the face value of the promissory notes.
  • Deferred tax liabilities: They arise from the difference between the recognized tax amount and the actual tax amount paid to the authorities. Essentially, it means that the company “underpays” the taxes in the current period and “overpays” the taxes at some point in the future.
  • Mortgage payable/long-term debt: If a company takes a mortgage or a long-term debt, it records the face value of the borrowed principal amount as a non-current liability on the balance sheet.
  • Capital lease: Capital lease recognized as a liability when a company enters into a long-term rental agreement for an equipment. The capital lease amount is a present value of the rental’s obligation.

 

Contingent Liabilities

Contingent liabilities are a special type of liabilities. They are the probable liabilities that may arise depending on the outcome of the uncertain future event.

A contingent liability is recognized only if both following conditions are met:

  • The outcome is probable.
  • The liability amount can be reasonably estimated.

If one of the conditions is not satisfied, a company does not report a contingent liability on the balance sheet. However, it should disclose this item in a footnote on the financial statements.

One of the most common examples of the contingent liabilities is legal liabilities. Suppose that a company is involved in the litigation process. Due to the stronger evidence provided by the opposite party, the company expects to lose the case in court, which will result in legal expenses. The legal expenses may be recognized as the contingent liabilities because:

  • The expenses are probable.
  • The legal expenses can be reasonably estimated (based on the remedies asked by the opposite party).

 

Related Readings

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Accrued Expenses
  • Financial Accounting Theory
  • Notes Payable
  • Projecting Balance Sheet Items

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