A liability is an obligation of a company that results in the company’s future sacrifices of economic benefits to other entities or businesses. A liability, like debt, 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.
Liabilities can help companies organize successful business operations and accelerate value creation. However, poor management of liabilities may result in significant negative consequences, such as a decline in financial performance or, in a worst-case scenario, bankruptcy.
A company reports its liabilities on its 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 Russian Accounting Principles (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.
Liabilities are future sacrifices of economic benefits that a company is required to make to other entities due to past events or past transactions.
Properly managing a company’s liabilities is crucial to avoid a solvency crisis, or in a worst-case scenario, bankruptcy.
Liabilities can be classified into three categories: current, non-current and contingent.
Current vs. non-current liabilities
The primary classification of liabilities is according to their due date. The classification is critical to the company’s management of its financial obligations.
Current liabilities are those that are due within a year. These primarily occur as part of regular business operations. Due to the short-term nature of these financial obligations, they should be managed with consideration of the company’s liquidity. The most common current liabilities are:
Accounts payable: These are the yet-to-be-paid bills to the company’s vendors. Generally, accounts payable are the largest current liability for most businesses.
Interest payable: interest expense that has already been incurred but has not been paid. Interest payable should not be confused with interest expense, which is the expense on an income statement.
Income taxes payable: the income tax amount owed by a company to the government. The tax amount owed must generally be payable within one year. Otherwise, the tax owed would be classified as a long-term liability.
Bank account overdrafts: effectively, a type of short-term loan provided by a bank when a payment is processed with insufficient funds available in the bank account
Accrued expenses: expenses that have been incurred but no supporting documentation (e.g., invoice) has been received or issued to the company by the vendor
Deferred revenue:(also called unearned revenue). Generated when a company receives early payment for goods and/or services that have not been delivered or completed yet.
Short-term loans or current portion of long-term debt: loans or other borrowings with a maturity of one year or less
Current liabilities are used as a key component in several short-term liquidity measures. Below are examples of metrics that management teams and investors look at when performing financial analysis of a company.
Examples of key ratios that use current liabilities are:
The quick ratio: current assets, minus inventory, divided by current liabilities
The cash ratio: cash and cash equivalents divided by current liabilities
Non-current (long-term) liabilities are those that are due after more than one year. It is important that the non-current liabilities exclude the amounts that are due in the short-term, such as short-term loans or the current portion of long-term debt.
Non-current liabilities can be a source of financing, as well as amounts arising from business operations. For example, bonds or mortgages can be used to finance a company’s projects. Non-current liabilities are critical to understanding the overall liquidity and capital structure of a company. If companies cannot repay their long-term liabilities as they become due, the company will face a solvency crisis and potential bankruptcy. 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 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 value of the promissory notes.
Deferred tax liabilities: These arise from the difference between the amount of tax recognized on the income statement and the actual tax amount due to be paid to the appropriate tax authorities. As a liability, it essentially means that the company “underpays” the taxes in the current period and will “overpay” the taxes at some point in the future.
Mortgage payable/long-term debt: If a company takes out a mortgage or a long-term debt, it records the value of the borrowed principal amount as a non-current liability on the balance sheet.
Leases: Leases are recognized as a liability when a company enters into a long-term rental agreement for property or equipment. The lease amount is the present value of the lessee’s obligation.
Contingent liabilities are a special category of liabilities. They are possible liabilities that may or may not arise, depending on the outcome of an uncertain future event. A contingent liability is recognized only if both of the 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 contingent liabilities is legal liabilities. Suppose that a company is involved in litigation. 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 contingent liabilities because:
The expenses are probable
The legal expenses can be reasonably estimated (based on the remedies asked by the opposite party)