What Is a Liability?
A liability is something a person or company owes, usually money. Liabilities are settled over time by transferring economic benefits, including cash, goods, or services.
On the right side of the balance sheet, liabilities include loans, accounts payable, mortgages, deferred revenues, bonds, warranties, and accrued expenses.
Liabilities can be contrasted with assets. Liabilities refer to things you owe or have borrowed; assets are things you own or are owed.
KEY TAKEAWAYS
- A liability (generally speaking) is owed to somebody else.
- Liability can also mean a legal or regulatory risk or obligation.
- In accounting, companies book liabilities in opposition to assets.
- Current liabilities are a company’s short-term financial obligations due within one year or a standard operating cycle (e.g., accounts payable).
- Long-term (non-current) liabilities are obligations on the balance sheet that are not due for more than a year.
How Liabilities Work
A liability is an obligation between one party and another not yet completed or paid for. In accounting, a financial penalty is also an obligation. Still, it is defined more by previous business transactions, events, sales, exchange of assets or services, or anything that would provide economic benefit later. 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 a due 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.
A company’s liabilities are vital because they finance operations and pay for significant 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. Instead, it invoices the restaurant for the purchase to streamline the drop-off and make paying more effortless for the restaurant.
The great money the restaurant owes to its wine supplier is a liability. In contrast, the wine supplier considers the money it is owed to be an asset.
Important:
Liability may also refer to the legal liability of a business or individual. For example, many companies take out liability insurance if a customer or employee sues them for negligence.
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. When a retailer collects sales tax from a customer, they have a sales tax liability on their books until they remit those funds to the county/city/state.
Liability can also refer to one’s potential damages in a civil lawsuit.
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 are debts payable over a more extended period. For example, if a business takes out a mortgage payable over 15 years, that is a long-term liability. However, the mortgage payments 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 (Near-Term) Liabilities
Ideally, analysts want to see that a company can pay current liabilities due within a year with cash. Some 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, like individuals, often use credit to purchase goods and services to finance over short 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 yearly until the dividend is paid.
- Unearned Revenues: A company’s liability to deliver goods and services at a future date after being paid in advance. This amount will be reduced with an offsetting entry once the product or service is provided.
- Liabilities of Discontinued Operations: This is an outstanding liability that most people glance over but should scrutinize more closely. Companies must account for the financial impact of an operation, division, or entity currently being held for sale or has been recently sold. This also includes the economic impact of a product line that has recently been shut down.
Non-Current (Long-Term) Liabilities
Considering the name, it’s pretty evident that any liability that is not near-term 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 may list one or two things. Long-term debt, or bonds payable, is usually the most significant liability at the top.
Companies of all sizes finance part of their ongoing long-term operations by issuing bonds that are essentially loans from each party that purchases the bonds. This line item is in constant flux as bonds are issued, matured, or called back by the issuer.
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 must be estimated. The estimated time and money may be spent repairing products upon a warranty agreement. This is a standard 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 broad category may be recorded as current or non-current, depending on the specifics of the transactions. These credits are revenue collected before it is recorded as earned on the income statement. 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.
- Post-Employment Benefits: These are benefits an employee or family member may receive upon his/her retirement, which are carried as a long-term liability as it accrues. In the AT&T example, this constitutes one-half of the non-current total, second only to long-term debt. This liability is not overlooked with rapidly rising health care and deferred compensation.
- Unamortized Investment Tax Credits (UITC): This represents the net between an asset’s historical cost and the amount that has already been depreciated. The unamortized portion is a liability, but it is only a rough estimate of the asset’s fair market value. For an analyst, this details how aggressive or conservative a company is with its depreciation methods.
