Remember the time when you thought it best to settle something over time by either paying cash, giving up a piece of your land, or rendering a certain amount of hours working on an assigned task? That, my friend, is a settlement of a liability! And this is quite similar to the definition of a liability in the accounting domain.
Found on the rightmost part of the Statement of Financial Position or Balance Sheet, liabilities include the following: notes payable to banks or other financial institutions, accounts payable, loans, mortgages, bonds, deferred revenues, accrued expenses, payroll taxes payable, sales or percentage tax payable, income tax payable, VAT or value-added tax payable, and even warranties.
It represents the amount of debt due to a company or person by the company. Liabilities, stated differently, are outstanding amounts owed to creditors or non-owners of the company. They are a fundamental aspect of any company for the reason that they are employed to shoulder significant expansions and finance operations.
Also, they can make transactions amid businesses more productive. For example, if a supplier sells chicken to an eatery, it usually does not demand immediate payment after each daily delivery. Instead, it charges the restaurant through a duly-received delivery receipt that summarizes all deliveries made in a week or so.
This statement of account or billing is then sent for collection to the eatery within an agreed interval. Now, does this not make the paying stress-free for the eatery? The outstanding amount that the eatery owes to the chicken supplier represents its liability.
On the side of the chicken supplier, the amount owed by the eatery is an asset, specifically accounts receivable, which is a current asset. Liability may likewise signify legal commitment, which compels many businesses to set up liability insurance for cases where an employee or customer takes legal action against them due to negligence.
Another example is when retailers have to remit to the government their collected monthly value-added tax that is usually due on the 15th day of the succeeding month. So, let us assume that the total output tax, which is the tax collected from the buyers, is $1,000. Then, during the same month, the input tax, which is the tax paid by the company in its purchases, is $500.
And this results in a VAT Payable of $500 reflected in the Balance Sheet of the company at the end of the said month. The liability is taken up in the accounting books through an adjusting entry made by the accountant since it is unpaid as of the end of the month.
In the accounting domain, a monetary liability is similarly an obligation, although more expressed by previous commercial transactions, sales, events, exchange of services or assets, or anything that offers an economic benefit for a later period. Then, just like assets, liabilities are also classified as short-term or current and long-term or non-current, depending on the settlement happening within or beyond 12 months.
Types of Liabilities
Subject to the circumstances, liabilities are likewise known as short-term or long-term. It can take account of an upcoming service due to others; borrowings from banks, other entities, or people, irrespective of its terms; or, an earlier transaction that created an unpaid obligation.
The usual liabilities usually exist as the biggest, like bonds and accounts payables. Most companies have these account titles on their Statement of Financial Position or Balance Sheet because they are segments of ongoing short-term and long-term business operations.
These liabilities contain debts that are due within a year. They stay listed on top of the Statement of Financial Position or Balance Sheet, opposite the Assets section, to show creditors and investors the amount the company has to shell out to its existing creditors within the year.
This section usually includes accrued expenses, VAT payable, accounts payable, payroll taxes payable, payroll or salaries and wages payable, and sales or percentage tax payable. In the case of a mortgage with a payment term of 10 years, only the amount payable for the current year is a current liability.
The remaining amount is then recognized as a Long-term Liability. Ideally, financial statement readers want to tell that a business can pay its current liabilities that are due in 12 months with cash. Some examples of short-term liabilities are as follows:
- Accrued expenses payable – These are obligations that a company has incurred but have yet not been taken up in the accounting books. And this happens when the suppliers fail to send invoices at the end of the accounting period.
Hence, this transaction enters the book of accounts through a reversing journal entry made by the accountant that, as implied by the name, automatically reverses within the next reporting period.
- Dividends Payable – This is the amount due to shareholders following a dividend declaration for corporations that have given out stock to stockholders and paid a dividend. The period involved is around 15 days, so this obligation usually turns up each quarter until the full payment of the dividend is achieved.
- Interest Payable – Just like people, companies frequently use credit in their dealings, especially in buying services and goods to finance short periods of operation. This account title signifies the interest expense on those current credit purchases subject for payment.
- Liabilities of Discontinued Operations – This is a rare liability that many people read quickly, but in reality, requires more scrutiny. Companies are obliged to explain the economic effect of a division, operation, or entity being put up for sale, if not already sold recently.
Also, this takes account of the effect on the finances of a line of products that folded up lately. The entry draws attention to the knock-on effect in total since most firms do not record each business segment or merchandise in its financial statements. And as estimates are used in several calculations, this is capable of carrying significant importance.
For example, a large tech company announced what it believed a world-changing merchandise line. Shortly after, the said product flopped when it reached the market. In this case, all the costs covering research and development, marketing, and launching the merchandise on the market must be explained under this account title.
- Salaries and Wages Payable – This is the total of accrued revenue that employees earned, but not paid by the company yet. Since most businesses pay their staff every 15 days, this current liability often changes.
- Unearned Revenues – This account title shows the liability of a company to deliver services and/or goods at a later date after receiving advance payment. This amount is generally reduced with an adjusting entry when the service and/or product is delivered.
These liabilities consist of commitments that fall due on a date exceeding the next 12 months. The most usual long-term debts are long-term bonds and banknotes or notes payable. Long-term liabilities exist listed following Current Liabilities because they stay less relevant towards the current company cash position.
Portions of continuing liabilities, however, can be taken up under the current liabilities, as previously mentioned. These long-term liabilities are paid with resources derived from potential financing transactions or earnings. Aside from long-term loans and bonds, items like deferred taxes, rent, payroll, and retirement fund obligations are also listed as long-term liabilities.
Bonds payable or long-term debt is typically the most substantial obligation of a company; and, thus, is shown first on the list. Businesses of any size finance a portion of their continuing long-term operations through bond issuance that is, in essence, a loan from every person or entity who purchased the bonds.
And as a result, the amount in this account title is in steady flux due to bonds issue, maturing, or recalled by the issuing company. Let us now take a closer look at some customary Long-term Liabilities.
- Contingent Liability Evaluation – This liability can occur subject to the result of a tentative future event.
- Deferred Credits – In reality, this stands as a broad group that can be recorded either as non-current or current subject to the details of the business deal. These credits exist revenue received ahead of being earned, besides documented and noted on the Profit and Loss Statement.
It may take account of deferred revenue, customer advances, or a deal where credits stay due, but still not considered as revenue. When the income is not deferred any more, the reported amount in this account title is decreased by the sum earned and turns a fraction of the revenue stream of the company.
- Post-Employment Benefits – This account title reveals the benefits of a hired worker or his/her family members can receive upon the retirement of the said employee. The amount involved is carried by way of a long-term commitment as it accumulates.
On certain occasions, this amount can make up 50% of the entire non-current; and, thus, shown after long-term debt or bonds. So, with a rapidly rising deferred compensation and health care cost, this liability must not be overlooked.
- UITC or Unamortized Investment Tax Credits – This signifies the net amid the historical cost of an asset and its corresponding depreciation. The unamortized part is an obligation, but it remains only an estimation of the fair market value of the asset. For a financial statement user, this provides specific details of the degree of aggressiveness or conservatism of a company in its depreciation systems.
- Warranty Liability – Several liabilities stay not as correct as accounts payable; and, therefore, needs estimation. It is the estimated value of money and time that might be spent patching up products on the warranty agreement that comprises this particular liability. In the auto industry, however, this remains a standard commitment as most vehicles have long-term guarantees that are often costly.
Liabilities in the Basic Accounting Equation
Assets stand as stuff belonging to a company, such as machinery, buildings, equipment, interest and accounts receivables, patents, intellectual property, among many others. If a company subtracts its obligations from its resources, the difference exists as its equity. This association is expressed in the basic accounting equation:
$$Assets - Liabilities = Equity$$
In most instances, however, this accounting reckoning is commonly shown as:
$$Assets = Liabilities + Equity$$
Liability versus Expense
Expenses are the operation cost that a business incurs to create revenue. Unlike real accounts, specifically liabilities and assets, expenses, a nominal account, are linked to income. Note that real accounts are shown in the Statement of Financial Position or Balance Sheet of a company.
In contrast, nominal accounts are shown on the Income Statement or Profit and Loss Statement of the company. Without any doubt, expenses are necessary for computing net income following the simple equation of:
$$Net\: income = Revenues - Expenses$$
For instance, if a business has more costs than sales for the last two years, it signals a weak financial strength as it has lost money for the said years. Given this explanation, liabilities and expenses must never be mixed up.
After all, Expenses stand as the operating costs of the company, while Liabilities exist as the debts the company owes. Also, expenses may be paid anytime with cash within the current year. Failure to so only creates another liability.