What are Liabilities? – Definition
Liabilities are probable, non-ownership claims against the firm which must arise from events that occurred in the past and be expected to be satisfied in the future. Liabilities can be held by owners if they originate through transactions in which the owners acted in the capacity of nonowners.
For example, the firm would incur and report a liability that arose by borrowing cash from an owner. In some special cases, it could be held that the claim is more like equity than a liability. This definition excludes claims that are expected to arise from events that will happen in the future. If this exclusion did not exist, it would be necessary to record all future cash outflows as liabilities. Instead, accountants recognize only claims that have come about because of past events.
Liabilities originate from a variety of activities; the major origins include:
- Borrowing cash or other assets.
- Postponing payment to suppliers.
- Accepting cash from customers in advance of the performance.
- Incurring tax levies.
- Incurring fines.
- Settling or losing litigation.
- Acting as a third party to a transaction (such as withholding payroll taxes).
Thus, some liabilities are incurred in the normal course of business as a management choice whereas others are imposed on the firm by governmental authorities.
How to recognize a liability?
To recognize a liability, a firm need not know the actual recipient of the assets that are to be transferred or for whom the services are to be performed. For example, when General Motors guarantees or warrants an automobile, a liability must be recorded, even though at the time of sale GM does not know which particular customer’s automobile may require repair.
In order for a liability to exist, an event or transaction must already have occurred. In effect, only present, not future, obligations are liabilities. For example, the exchange of promises of future performance between two firms or individuals does not result in the recognition of liability or the related asset. The signing of a labor contract between a firm and an individual does not cause the firm to recognize a liability. Rather, the liability is recognized when the employees perform services for which they have not yet been compensated. In the automobile warranty case, the liability occurs at the time of sale because at that time the firm obligates itself to make certain repairs. Thus, the event has occurred and a present obligation is Incurred.
When reporting about a liability, accountants are always concerned with these three questions:
1. Will it have to be paid?
2. How much will have to be paid?
3. When will it have to be paid?
Answering the first question requires that the accountant determine the likelihood that the payment will be made. Because a liability impacts both earning power and solvency, the answer to the question must be carefully developed and can result in either recognition of a liability on the balance sheet or description of the situation in a note.
The answer to the question regarding the amount to be paid clearly impacts assessments of solvency and earning power. Information about the size of the future cash flows to existing creditors helps investors and potential creditors assess the likelihood of their receiving future cash flows from the firm. The size of the liability also contributes to evaluations of management’s use of leverage.
The answer to the question of when the amount is to be paid enables the statement user to assess separately the short- and long-run solvency of the company. In many cases, the accountant also presents additional information about the liabilities such as the type of creditor, the reason that the liability was created and the existence of collateral agreements.
For example, these disclosures may reveal the existence of related-party transactions between the firm and its managers, major stockholders, or suppliers. Because the liability may have originated from a nonarm’s-length transaction, GAAP require full disclosure concerning the party that is to be paid when a related party is involved. The identification of the type of creditor may also be helpful in allowing the statement user to determine how others (such as the bond market, banks, and finance companies) have assessed the solvency of the firm.
Disclosures related to the liabilities of National Distillers and Chemical Corporation are illustrated in the following example.
Accounting for liabilities has been shaped for the most part by common practice. Several authoritative pronouncements have been issued in order to bring consistency where common practices were not uniform. This chapter examines the following aspects of accounting for liabilities:
- Time to maturity.
- Accrued liabilities.
- Third-party liabilities.
- Collateral agreements.
- Deferred credits.