What it means
A liability arises when a past event creates an obligation that the business will probably have to settle. Buying goods on credit creates a liability to the supplier, borrowing from a bank creates a liability to the lender, and employing staff creates a liability for wages and holiday pay earned but not yet paid.
The common feature is a present duty to give up something of value. Liabilities are normally split into current and non-current.
Current liabilities are due within a year or the normal operating cycle, and include trade payables, accrued expenses, short-term borrowings and the part of long-term debt due soon. Non-current liabilities fall due later, such as long-term loans, bonds and lease obligations.
Some liabilities are certain in amount, such as a loan balance. Others are estimates, such as warranty provisions or legal claims, where the business must judge the likely cost.
A possible obligation that is not probable or cannot be measured reliably is usually disclosed in the notes as a contingent liability rather than recorded on the balance sheet. Liabilities are not bad in themselves.
Borrowing can fund growth, and supplier credit is a cheap form of finance. The issue is balance, which is why lenders and analysts examine ratios such as current ratio, debt to equity and interest cover to judge whether the company can meet what it owes.
The accounting equation ties it all together: assets equal liabilities plus equity. Whatever the business owns is funded either by what it owes or by what the owners have put in or retained.
A rise in liabilities without a matching rise in assets means equity has fallen. Measurement follows the nature of the obligation.
Trade payables are recorded at the invoice amount, loans at the amount borrowed plus accrued interest, and provisions at the best estimate of the cost of settling the obligation. Where the payment is far in the future, the estimate may be discounted to present value.
In practice
Real-world examples
Example 1
A furniture maker buys $30,000 of timber on 45-day credit terms. On the day of purchase, inventory rises by $30,000 and trade payables, a liability, rise by the same amount. When the invoice is paid, cash falls and the liability disappears.
Example 2
A software company bills customers annually in advance. The cash received for service not yet delivered is recorded as deferred revenue, a liability, because the company owes the service. It is released into revenue month by month as the service is provided.
Example 3
A restaurant group has a pending legal claim from a customer. Its lawyers judge that a payment is probable and can estimate the amount at $75,000. The group records a provision, which is a liability, and notes the uncertainty in its accounts.
Think of it
Imagine your finances like a seesaw. On one side, you have what you own (assets), and on the other side, you have what you owe (liabilities). Keeping the seesaw balanced is important, so the more you owe, the more you need to own to keep things steady.
Formula
Calculation
Liabilities = Assets - Equity
Total liabilities = Current liabilities + Non-current liabilities
A company has total assets of $850,000 and owners' equity of $350,000, so its liabilities are 850,000 - 350,000 = $500,000. Its current liabilities are trade payables of $120,000, accrued expenses of $40,000 and a short-term loan of $90,000, which total 120,000 + 40,000 + 90,000 = $250,000. Its non-current liabilities are a $250,000 bank term loan. Total liabilities are 250,000 + 250,000 = $500,000, which matches the first calculation.Case study
Seen in the real world
Pinecrest Outdoor Supplies is an illustrative, fictional retailer that was growing quickly. The owner looked at the profit and loss account and felt secure, but the new finance manager showed him a balance sheet in which liabilities had grown from $600,000 to $1,400,000 in a year. Much of the growth came from supplier credit and a new bank loan used to stock more products.
The finance manager worked out that current liabilities were now much higher than cash and receivables. She arranged a longer-term loan to replace part of the short-term borrowing and negotiated longer supplier terms. The illustrative lesson was that a profitable business can still run into trouble if its liabilities fall due before its cash arrives.
Watch out
Common mistakes
- Thinking liabilities means only bank loans, when trade payables, accruals, deferred revenue and provisions also count.
- Treating all liabilities as dangerous, when supplier credit and moderate borrowing are normal and useful.
- Ignoring liabilities that are not on the balance sheet, such as contingent claims and commitments disclosed in the notes.
Questions
People also ask
What is the difference between a liability and an expense?
A liability is an amount owed at a point in time and sits on the balance sheet, whereas an expense is a cost incurred during a period and sits in the profit and loss account.
Is deferred revenue really a liability?
Yes, because the company has received payment and owes the customer a product or service in return.
How are liabilities used to judge financial health?
Analysts compare them with assets, equity and cash flow using ratios such as the current ratio and debt to equity.
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