What Is a Liability?

What Is a Liability?

Liabilities are the combined debts and obligations that an individual or company owes to outside parties. Everything the company owns is classified as an asset and all amounts the company owes for future obligations are recorded as liabilities. On the balance sheet, total assets minus total liabilities equals equity.

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. 

Liabilities are usually considered short term (expected to be concluded in 12 months or less) or long term (12 months or greater). They are also known as current or non-current depending on the context. 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.

How Liabilities Work

Liabilities can be described as an obligation between one party and another that has not yet been completed or paid for. They are settled over time through the transfer of economic benefits, including money, goods, or services.

Liabilities consist of many items ranging from monthly lease payments, to utility bills, bonds issued to investors and corporate credit card debt. Money received by an individual or company for a service or product that has yet to be provided or delivered, otherwise known as unearned revenue, is also recorded as a liability because the revenue has still not been earned and represents products or services owed to a customer.

Future pay-outs on things such as pending lawsuits and product warranties must be listed as liabilities, too, if the contingency is likely and the amount can be reasonably estimated. These are referred to as contingent liabilities. 

Types of Liabilities

On the balance sheet, a company’s total liabilities are generally split up into three categories: short-term, long-term, and other liabilities. Total liabilities are calculated by summing all short-term and long-term liabilities, along with any off-balance sheet liabilities that corporations may incur.

Short-term liabilities

Short-term, or current liabilities, are liabilities that are due within one year or less. They can include payroll expenses, rent, and accounts payable (AP), money owed by a company to its customers.

Because payment is due within a year, investors and analysts are keen to ascertain that a company has enough cash on its books to cover its short-term liabilities.

Long-term liabilities 

Long-term liabilities, or noncurrent liabilities, are debts and other non-debt financial obligations with a maturity beyond one year. They can include debentures, loans, deferred tax liabilities, and pension obligations.

Less liquidity is required to pay for long-term liabilities as these obligations are due over a longer timeframe. Investors and analysts generally expect them to be settled with assets derived from future earnings or financing transactions. One year is generally enough time to turn inventory into cash.

Other liabilities

When something in financial statements is referred to as “other” it typically means that it is unusual, does not fit into major categories and is considered to be relatively minor. In the case of liabilities, the “other” tag can refer to things like intercompany borrowings and sales taxes.

Investors can discover what a company’s other liabilities are by checking out the footnotes in its financial statements.

Liabilities vs. Assets

An owner’s equity or stockholder’s equity is calculated by subtracting a business’s liabilities from its assets. The relationship can be expressed as follows:

Assets−Liabilities=Owner’s Equity

However, in most cases, this accounting equation is commonly presented as such:

Assets=Liabilities+Equity

Liabilities and assets are the opposites of each other, yet people often get confused. While assets are things that contribute positive cash flow to a person’s finances, liabilities are those that create negative cash flow, or money that leaves an individual’s accounts every month.

For example, a house that an individual owes money on and makes monthly payments on is a liability, not an asset. The house takes money from the person in the form of monthly mortgage payments each month.

For a house to be an asset, it would have to be completely paid off. Even still, if monthly taxes and insurance payments are being made, then technically it would still be a liability.

Houses can only be assets really and truly when they are rented out and the rental income that a person receives is greater than all of the expenses associated with the house every month, including any mortgage payments, taxes, insurance, upkeep, and property management fees. When the net result of a property is money coming in, then it is an asset and not a liability.

Liabilities vs. Expenses

Expenses and liabilities may seem to be interchangeable terms, but they aren’t. Expenses are what your business pays each month to fund operations. Liabilities, on the other hand, are the obligations and debts you’ve to other parties.

In a sense, expenses are a subset of your liabilities, but are used differently to track the financial health of your business. Immediate payment of expenses keeps your business afloat. On your balance sheet, business expenses are reflected by drawing down your cash account or increasing accounts payable.

Expenses are more immediate in nature, and you pay them regularly. They’re then reflected in your monthly income statement to determine the net profit of your business.

If you don’t pay an expense, it becomes a liability. Let’s say you can’t afford to pay cash for the monthly purchase of office supplies. You decide to take out a loan to pay for this expense, which then becomes a liability. However, you’ll continue to report the expense monthly on your company’s income statement to determine net income.

Examples of Liabilities

Liabilities are legal obligations payable to a third party. A promise to make a payment at a future date is a liability. A liability is recorded in the general ledger in a liability account with a natural credit balance. The following list contains a number of examples of liability accounts divided into current and non-current liabilities:

Current Liability Accounts (due in less than one year):

  • Accounts payable. Invoiced liabilities payable to suppliers.
  • Accrued liabilities. Liabilities that have not yet been invoiced by a supplier, but which are owed as of the balance sheet date.
  • Accrued wages. Compensation earned but not yet paid to employees as of the balance sheet date.
  • Customer deposits. Payments made by customers in advance of the seller completing services or shipping goods to them. If the goods or services are not provided, the company has an obligation to return the funds.
  • Current portion of debt payable. Any portion of long-term debt that is due for payment within one year.
  • Deferred revenue. A payment by a customer that has not yet been earned by the company.
  • Income taxes payable. Income taxes payable to the government.
  • Interest payable. Interest accrued on debt that has not yet been invoiced by the lender.
  • Payroll taxes payable. Taxes payable that result from the completion of a recent payroll transaction.
  • Salaries payable. Compensation owed to employees, typically to be paid out in the next payroll cycle.
  • Sales taxes payable. Sales taxes charged to customers, which the company must remit to the applicable taxing authority.
  • Use taxes payable. Use taxes are essentially sales taxes that are remitted directly to the government having jurisdiction, rather than through a supplier who would otherwise remit the tax.
  • Warranty liability. A reserve for any warranty liability associated with sales, for which warranty claims have not yet been received.

Long Term Liability Accounts (due in more than one year):

  • Bonds payable. The remaining principal balance on bonds outstanding that is due for payment in more than one year.
  • Loan payable. Debt that is due for payment in more than one year.

There are also a small number of contra liability accounts that are paired with and offset regular liability accounts. These contra accounts have a natural debit balance. One of the few examples of a contra liability account is the discount on bonds payable (or notes payable) account.

Frequently Asked Questions About Liabilities

How Are Current Liabilities Different From Long-Term (Noncurrent) Ones?

Current liabilities of a company consist of short-term financial obligations that are typically due within one year. Current liabilities could also be based on a company’s operating cycle, which is the time it takes to buy inventory and convert it to cash from sales.

Long-term liabilities are financial obligations of a company that are due more than one year in the future. The current portion of long-term debt is listed separately to provide a more accurate view of a company’s current liquidity and the company’s ability to pay current liabilities as they become due.

How Do I Know If Something Is a Liability?

Liabilities are things borrowed from, owed to, or obligated to others. Whether it’s real (e.g. a bill that needs to be paid) or potential (e.g. a lawsuit that may be filed).

Liabilities are not always bad. When a company expands and grows, it may incur debt (a liability). If a person desires to buy a home, he or she may also take out a mortgage.

How Do Liabilities Relate to Assets and Equity?

According to the accounting equation, assets equal liabilities plus equity. By rearranging the formula, we can read liabilities = assets – equity. In this case, total liabilities equal total assets minus shareholders’ equity. The value of the firm’s equity position must decrease if it takes on more liabilities without accumulating more assets.

What Are Examples of Liabilities That Individuals or Households Have?

The net worth of an individual or household is calculated by balancing assets and liabilities. Most households have liabilities such as taxes, bills, rent, mortgage payments, and loan interest and principal. A pre-paid service or work may also be considered a liability if you are not paid for it.

What Is a Contingent Liability?

A contingent liability is a liability that may occur depending on the outcome of an uncertain future event. A contingent liability is recorded if the contingency is likely and the amount of the liability can be reasonably estimated. The liability may be disclosed in a footnote on the financial statements unless both conditions are not met.

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