Liabilities

What are Liabilities? 

A liability is a financial obligation a company owes to outside parties, and is a key component of the balance sheet used in risk assessment, debt ratios, and cash flow analysis.

How are liabilities used in Finance?

• They appear on the balance sheet, which indicates the financial status of the company. A high level of liabilities may indicate increased financial obligations and potential risk, depending on the company's ability to repay
• Therefore, liabilities are considered for risk assessment and calculating debt ratios 
• They are related to a firm’s financial decisions and, hence, its capital structure. If a company has a high debt ratio, it’s more likely to face a higher cost of issuing debt and therefore may have a preference for equity 
• They are used in cash flow projections in the form of future payments and obligations

Classification of Liabilities

Liabilities include both short-term and long-term, as well as contingent liabilities, which occur when a company believes a loss is predictable and estimable.

Current Liabilities (Short-term)

Current Liabilities are liabilities that are usually due within a year. Examples include:

• Accounts Payable: The amount the firm has not yet paid back to its suppliers or service providers for the goods and services. The company initially purchases these goods and services on credit and then records them as liabilities 
• Short-term Debts: Borrowings due within one year, including bank loans and other instruments used to manage liquidity 
• Dividends Payable: Dividends that have not yet been distributed to shareholders
• Accrued Expense: Expenses that are incurred but not yet paid. For instance, wages have not yet been paid to employees
• Interest payable: Accrued interest on outstanding debt instruments that have not yet been paid
• Unearned revenue: Money received before the goods and services were delivered  

Non-Current Liabilities (Long-term)

Non-current liabilities are liabilities that typically last longer than one year. Examples include:

• Long-term debt: 
  • Loans Payable: Long-term borrowings from banks and other financial institutions that are due after more than one year 
  • Notes Payable: Notes that shall be repaid with a maturity of longer than 12 months
  • Bonds Payable: Amount owed to bondholders for bonds issued by the company, including interest obligations
  • Leases Payable: Lease obligations extending beyond 12 months, which are split into current and non-current portions on the balance sheet
• Deferred income taxes and other liabilities: Taxes owed in future periods due to temporary differences between accounting income and taxable income

Contingent Liabilities

Contingent Liabilities are potential obligations of a firm when the loss is probable and estimable. 

They may include:

• Lawsuits: If a company is involved in a lawsuit and determines that a loss is probable and can be reasonably estimated, it records the potential loss as a contingent liability
• Environmental Cleanup Costs: The company may be required to clean up waste or contamination following government regulations 

Liability vs. Asset

It’s often said that assets and liabilities are two sides of the same coin. Both of them are recorded on the balance sheet with shareholders’ equity. In short, an asset is what the firm owns, and a liability is what the firm owes to others. 

The Basic accounting equation and shareholders’ equity

The most basic equation in accounting is the relation between assets, liabilities, and shareholders’ equity. This section explains the equation and the definition of shareholders’ equity. 

Shareholder’s Equity

• Shareholders’ equity is what appears on the bottom section of a balance sheet, the company’s net worth 
• The shareholder’s equity consists of common stock and retained earnings
  • Common Stock: The par value of shares issued to shareholders; total owner investment is captured more fully in paid-in capital
  • Retained Earnings: The sum of all prior net incomes, net of the sum of all prior dividends

The Basic Accounting Equation

One of the most basic accounting equations that connects assets and liabilities is:

Assets = Liabilities + Shareholders’ equity

That is, what the company owns is what it owes plus the owner’s claim/the residual interest. The equation must always balance in any balance sheet, as every transaction affects at least two of these accounts and maintains the balance. 

Conclusion

Liabilities are the credit items that usually appear on the right side of the balance sheet. In short, they are the items the firm owes to other parties.

Liabilities can be categorized as current and non-current liabilities; the former are due within a year, while the latter are due longer than a year. 

Current liabilities include items such as accounts payable, short-term debts, accrued expenses, and unearned revenue.

Non-current liabilities include long-term debts, deferred income taxes, and other liabilities. Aside from the two big categories, certain firms also record contingent liabilities. Contingent liabilities are recorded only when a loss is probable and reasonably estimable; otherwise, they may be disclosed in footnotes.

Liabilities and assets appear together in a balance sheet. The two items are the two sides of the same coin, and most transactions that alter liabilities are likely to alter the asset side. 

The basic accounting equation is: Assets = Liabilities + Shareholders’ Equity, meaning equity equals assets minus liabilities.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Audit Risk Model
• Book Value
• Contingent Liability
• Differential Cost
• Lease Accounting