What Is a Liability?
A liability, in general, is an obligation to, or something that you owe somebody else. Liabilities are defined as a company's legal financial debts or obligations that arise during the course of business operations. They can be limited, or unlimited liability. 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, and accrued expenses.
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. Liabilities are usually considered聽short term聽(expected to be concluded in 12 months or less) or long term (12 months or greater).
Liabilities 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聽accounts payable聽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.
What's a Liability?
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 dropoff 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.
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.
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.
Current Versus Long-Term 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.
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 includes money owed to vendors, monthly utilities, and similar expenses. In contrast, analysts want to see that long-term liabilities can be paid with assets derived from future earnings or financing transactions. Debt is not the only long-term liability companies incur. Items like rent, deferred taxes, payroll, and pension obligations can also be listed under long-term liabilities.
The Relationship Between Liabilities and Assets
Assets are the things a company owns鈥攐r things owed to the company鈥攁nd 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:
What Is the Difference Between an Expense and a Liability?
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 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 is 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.
Examples of Liabilities
As a practical example of understanding a firm's liabilities, let's look at a historical example using AT&T's (NYSE: T) 2012 balance sheet.
AT&T 2012 Balance Sheet
Using the聽AT&T聽(NYSE:T) balance sheet as of Dec. 31, 2012, current/short-term liabilities are segregated from long-term/non-current liabilities on the balance sheet. AT&T clearly defines its bank debt maturing in less than one year. 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 using聽long-term debt.
Like most assets, liabilities are carried at cost, not聽market value, and under聽GAAP聽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 like聽payroll, taxes, and ongoing expenses for an active company carry a higher proportion.
AP聽typically carries the largest balances, as they encompass the day-to-day operations. AP can include services,聽raw materials, office supplies, or any other categories of products and services where no聽promissory note聽is 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.
Examples of Common Current Liabilities
- Wages Payable:聽The total amount of聽accrued income聽employees have earned but not yet received. Since most companies pay their employees every two weeks, this liability changes often.
- Interest Payable:聽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:聽For companies that have聽issued stock to investors and pay a dividend, this represents the amount owed to shareholders after the聽dividend was declared. This period is around聽two weeks, so this liability usually pops up聽four times per year, until the dividend is paid.
Less Common Current Liabilities
- Unearned Revenues:聽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:聽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聽product line聽that is or has recently been shut down.
Since most companies do not report line items for individual entities or products, this entry points out the implications in aggregate. As there are estimates used in some of the calculations, this can carry significant weight.
A good example is a large technology company that has released what it considered to be a world-changing product line, only to see it flop when it hit the market. All the R&D, marketing and product release costs need to be accounted for under this section.
Considering the name, it鈥檚 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.
Companies of all sizes finance part of their ongoing long-term operations by聽issuing bonds that are essentially loans聽to each party that purchases the bonds. This line item is in constant flux as bonds are issued, mature, or called back by the聽issuer.
Examples of Common Non-Current Liabilities
- Warranty Liability:聽Some liabilities are not as exact as AP and have to be estimated. It鈥檚 the estimated amount of time and money that may be spent repairing products upon the agreement of a聽warranty. This is a common liability in the automotive industry, as most cars have long-term warranties that can be costly.
- Lawsuit Payable:聽This is another liability that is estimated and requires more scrutiny.聽If a lawsuit is considered probable聽and predictable, an estimated cost of all court, attorney and settled fees will be recorded. These are common line items for pharmaceutical and medical manufacturers.
Less Common Non-Current Liabilities
- Deferred Credits:聽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 prior to it being earned and聽recorded on the income statement. It may include customer advances,聽deferred revenue,聽or a transaction聽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.
- Post-Employment Benefits:聽These are benefits an employee or family members may receive upon his/her retirement, which are carried as a long-term liability as it聽accrues. In the AT&T example, this constitutes one-half聽of the total non-current total second only to long-term debt. With rapidly rising health care and聽deferred compensation, this liability is not to be overlooked.
- Unamortized Investment Tax Credits (UITC):聽This represents the net between an asset's聽historical cost聽and the amount that has already been depreciated. The unamortized portion is a liability, but it is only a rough estimate of the asset鈥檚聽fair market value. For an聽analyst, this provides some details of how aggressive or conservative a company is with its聽depreciation聽methods.