What is a Liability?

What is a Liability? | Accounting Smarts
Charles Hall

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Charles Hall

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June 10, 2022

A successfully run business maintains accurate and up-to-date financial records and reports. One such report is the balance sheet.

A successfully run business maintains accurate and up-to-date financial records and reports. One such report is the balance sheet.

The balance sheet gives an overview of your assets, liabilities and equity and documents your financial position at a particular point in time.

While each of the 3 categories mentioned above are important, this article focuses on liabilities.

Liabilities refer to something owed by a business to another person or company. In most cases, liabilities are monetary. However, they can be paid in services or goods, depending on the arrangement.

If you’re starting a new business and uncertain about basic accounting terminology, it can be a little nerve-wracking. The purpose of this article is to ease that anxiety. We’ve provided a comprehensive breakdown of what is a liability to ensure you have the basics under control.

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Types of Liabilities

A liability is an obligation by one party that is owed to another party but has not yet been paid. Liabilities are essential in running a business as they help a business owner better manage cash flow. In that sense they are crucial and inevitable and lead to an economic benefit as long as they are managed correctly.

For instance, a mortgage is one obligation most businesses encounter. It allows you to utilize office space by guaranteeing the payment of a portion of the total obligation every month rather than paying the entire cost up front. This is just one example of a liability, but there are various types of liabilities that will be discussed below.

Current Liabilities

Current liabilities are short-term financial obligations in a business. These are often payable within one year or within the operating cycle of the business. The operating cycle, also known as the cash conversion cycle, is the time it takes the company to purchase inventory and convert it into cash. So, a perfect example of a current liability is money owed to suppliers for inventory purchased. Other examples of current liabilities are any thing associated with accounts payable such as: rent, utilities, office supplies, phone services, and subscriptions.

How Current Liabilities are Settled

Current liabilities typically are paid with current assets thus avoiding the depletion of long-term assets or investments. Current assets and current liabilities are both short term in nature and are generated and retired in the normal course of business. Current assets would include cash and receivables. 

By comparing the balance of current assets to current liabilities is a good indicator of your business’ ability to clear its current liabilities. If you have more current liabilities to current assets, chances are your business isn’t handling debts wisely or isn’t as profitable as you hoped for.

Examples of Current Liabilities 

Current liabilities vary from one business to another, but for discussion purposes here are a few examples of different current liabilities not previously mentioned:

  • Dividends payable
  • Accounts payable
  • Notes payable (current portion due within 1 year)
  • Short-term debts
  • Interest payable on outstanding debts
  • Income taxes owed
  • Deferred revenue/deposits (customers payments who have not yet received their services)

Why Current Liabilities Matter

As a business or company owner, it’s crucial to stay on top of your accounts and know how much you owe in terms of current liabilities. Such information allows you to make the right decisions for your business and prevents financial surprises.

However, this information isn’t just beneficial for you. Your current liabilities are an area of interest to business analysts and creditors. Both parties will use a formula known as the current ratio to measure your business’ ability to settle its debts. With this formula, the analyst or creditor divides your current assets by your current liabilities.

Alternatively, they can use the quick ratio. It’s the same process, but here, they subtract your total inventories beforehand. This formula is a conservative measure of liquidity and only takes into account assets that can be quickly converted to cash. You need a number higher than one to show you’re capable of managing debts. If the number is too high, you’re not leveraging your assets appropriately.

Accounting for Current Liabilities

So, how and where do you account for current liabilities in your business? Once you’ve recognized that your business has received an economic benefit, you need to record it as a liability and also as an expense or asset.

For example, you’re running a hair product manufacturing company and you’ve received a $5 million supply of raw materials from a vendor payable within the next 90 days. Because you’re not planning to use these raw materials immediately the entry would look something like this:

  • Inventory $5,000,000
  • Accounts Payable $5,000,000 

The $5 million owed to the supplier should be recorded as a current liability in accounts payable and the debit would reflect and increase to inventory which is a current asset.

Long-term Liabilities

Long-term liabilities, also known as, non-current liabilities, are the type of liabilities that are not payable within one year or the company’s operating cycle. In a balance sheet, long-term liabilities are listed separately from current liabilities to give a clear overview of the company’s ability to settle its debts. Settling a long-term debit is much different than settling current debt.

Can Current Liabilities be Listed as Long-term Liabilities?

Long-term liabilities are listed after current liabilities on the balance sheet. Long term liabilities include such debt as: deferred tax, loans, pensions, and other long-term obligations. Ideally, if the money, service or goods owed are payable after 12 months, they are considered long-term liabilities.

However, there are cases when current liabilities are reclassified as long-term liabilities. This occurs when a short-term obligation cannot be met and is converted into a note payable with terms. Of course, this only happens when both parties agree to the arrangement. 

For example, if a liability is coming up in the operating cycle, but there’s a long-term investment that can be used to repay it, it will be listed as a long-term liability. However, for this to work, the long-term asset must have enough funds to cover the debt.

Examples of Long-term Liabilities

Similar to current liabilities, long-term liabilities vary from one company to another, depending on the nature of the business. Here are some examples of long-term liabilities:

  • Deferred revenues
  • Deferred compensations
  • Postretirement healthcare liabilities
  • Pension liabilities
  • Bonds payable
  • Long-term loans
  • Customer deposits
  • Mortgages
  • Car payments

Why Long-term Liabilities Matter

It may not seem necessary to concentrate on long-term liabilities due to their long-term nature. Why worry about something that is due years down the road? However, this is faulty thinking. Long-term liabilities take much more planning to ensure you have the money when the money is due. Long term debt could be the downfall of a business if it is not managed correctly.

Long-term liabilities significantly factor in when financing is needed. Analysts and creditors will review debt ratios and solvency ratios comparing total assets to long-term debt to assess credit worthiness. 

Another comparison is total debt to total equity, which gives lenders an idea of financial leverage. Long-term liabilities also provide insight into a company debt structure.

Contingent Liabilities

Contingent liabilities refer to liabilities that may or may not occur depending on the occurrence of an uncertain future event. The relevance of this liability depends on the probability of the contingency becoming a real liability, its timing and the ability to give an accurate estimate of the liability.

Why Should You Record Contingent Liabilities?

If you’re new to accounting, contingent liabilities may seem unnecessary. Why record something that may not happen in your financial records? Well, it’s a stipulation by both GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards).

According to both organizations, it’s crucial to record contingent liabilities because they’re connected to three important accounting principles. These include:

  • Materiality principle: This principle states that all crucial financial information and matters must be disclosed in financial statements. An item is regarded as material if it has the potential to impact the economic decision of someone using the company’s financial documents. A contingent liability has the potential to impact economic decisions and is, therefore, considered ‘material.’
  • Full disclosure principle:  This principle states that all significant details and facts related to a company’s financial performance must be disclosed in financial statements. A contingent liability has the potential to not only negatively affect the company’s net profitability but also its assets. Therefore, it must be recorded.
  • Prudence principle: This is an accounting principle that ensures a company doesn’t overstate assets and understate liabilities. Since contingent liabilities are uncertain, it’s crucial to add them to financial statements to give the real financial picture of the business.

Examples of Contingent Liabilities 

As we’ve mentioned, contingent liabilities are potential losses that may occur in the future or a business based on the outcome of certain events. Some examples include:

  • Lawsuits
  • Product warranties
  • Pending investigations

How to Record Contingent Liabilities

Like all liabilities, it’s crucial to ensure contingent liabilities show up in your balance sheet for accurate financial statements. So, how do you record something based on estimates and only a probability of happening?

High Probability Contingent Liabilities

Consider your company is facing a lawsuit for patent infringement. Due to the court proceedings, your lawyers advise there is a good chance of losing. If you lose you would be required to pay approximately $1 million in settlement. Because the impact would dramatically affect the company and the fact it has a high probability of happening you would be required to record the potential expense.

The entry would require a debit entry to record $1 million in legal expenses and a credit entry to the long-term contingent liability account. This is known as a high probability contingent liability.

Medium Probability Contingent Liabilities

If the probability of losing is not clear but the estimates are clear, the liability will be listed as a contingent liability in the financial documents’ footnotes section. This is an indication that there is a likelihood of the liability affecting the company’s financial position. For this reason, this information must not be left out.

Low Probability Contingent Liabilities

If it’s highly unlikely that your company will be sued or even lose money, there’s no need to include this information in your financial records. Most companies leave it out of their financial statements. However, it’s advisable to have it as a disclosure for such liabilities in case it’s required.

Benefits of Liabilities in Accounting

To someone who has no accounting experience, liabilities may seem like a bad thing. If anything, one would think it’s better to have as many assets as possible and limit the number of liabilities. But this couldn’t be further from the truth. Liabilities are actually very advantageous to a business. Some of these benefits include:

  • Makes it possible to assess the viability of a business: Assessors use liabilities and other financial statements to assess how viable a business is compared to its competition.
  • Helps determine fiscal health: Creditors, investors, and economists rely on a current business’ liabilities to determine its fiscal health.
  • Liabilities indicate long-term solvency: This indicates your business’ ability to repay its debts in the long-term.
  • They are crucial for the operation of small businesses: Through liabilities, you’re not only able to manage your operations but also acquire things faster without paying everything in cash.
  • Allows for expansion: Many businesses need extra space but don’t have the money to do it. Though liabilities like mortgages, you can place a down payment and get on a repayment plan that allows you to achieve your goals faster.

Disadvantages of Liabilities in Accounting

While liabilities accord businesses numerous advantages, they don’t come without limitations. Some of the disadvantages of liabilities in accounting include:

  • There’s no way out of payment: You must repay every vendor or creditor you owe even if your business fails. Failure to do so may result in serious legal action.
  • High interest rates: Some liabilities come at a very high interest rate that may affect your final profits.
  • Liabilities affect credit ratings: Any loan you take to advance your company or business will come up whenever you need more credit options. The more unpaid debts you have, the worse your credit score will be.
  • Liabilities can cause financial crisis: Overreliance on liabilities to get you out of financial constraints can lead to financial emergencies if you can’t handle them.
  • Investors prefer companies with fewer liabilities than assets: The more liabilities you have, the less profitable your business is perceived. Investors want an investment where more money is coming in than going out.

Liabilities vs. Assets: The Relationship

To make the most of your business's liabilities, it's crucial to understand their relationship to assets. As we mentioned, assets are items that the business owns. This can be anything from cash in the bank, cash payable, machinery, equipment, interest owed, intellectual property, and more.

If you subtract your liabilities from your total assets, what you get is the owner’s equity. This relationship is presented in what is known as the accounting equation.

Assets = Liability + Equity

Are Expenses and Liabilities the Same?

Most people often confuse expenses with liabilities or believe them to be the same. They are not the same. An expense is the money spent to run the business, while a liability only reflects money owed to other people by the business. In essence a liability only reflects unpaid expenses.

Another difference is that they’re not recorded in the same financial statements. Expenses are recorded in income statements and are compared to the revenue received. If a business has more expenses compared to their revenue for a period of time, it’s considered unprofitable or financially weak.

The goal is to ensure that the business has more income than expenditure. On, the other hand, liabilities are recorded on a balance sheet, and they’re compared to assets. However, similar to expenses, a business should strive to have more assets than liabilities to improve its solvency and investment opportunities.

Charles Hall

Charles Hall

Charles has spent 25 plus years in the world of accounting and business. His experience includes working as a CPA/Auditor international accounting firms. He has worked as a controller and as a COO for small to medium sized companies.

Learn more about Charles Hall