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 payables, mortgages, deferred revenues, bonds, warranties,
and accrued expenses. A liability is a financial obligation of a company that results in
the company’s future sacrifices of economic benefits to other entities or businesses.
A liability can be an alternative to equity as sources of a company’s financing.
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 considered short-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
like accounts payable and bonds payable. Most companies will have these two line
items on their balance sheet, as they are part of on-going current and long-term
operations.
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 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 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 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.
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.
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.
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 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.
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 being earned and recorded on income statements. 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.
