Liabilities

Accounting · Dec 25, 2019

Assets, liabilities and equity are three basic building blocks that form the balance sheet equation and any investor should have a deep understanding of what they mean. In this article, we’ll explain what liabilities are and we’ll also provide a real example using a balance sheet of a public company.

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Table of Contents

What are Liabilities?

Liabilities are defined as anything of value that a company owes to somebody (another companies, governments or individuals). Liabilities are often understood as the same thing as debt, i.e. financial obligations. Almost any company has some kind of liabilities on its balance sheet.

Formula

To calculate the value of company’s liabilities, given its assets and owner’s equity, use the following formula:

$$ L = A - E $$

Where:

  • L: Liabilities
  • A: Assets
  • E: Owner’s (shareholders') equity

Let’s imagine a company which has $2,500,000 worth of assets and $1,500,000 worth of net owner’s equity. How can we figure out company’s liabilities? It should be the difference between these two values - $1,000,000.

Negative Liabilities

As a general rule of accounting, most of the numbers in balance sheets are expected to have positive values, but on rare occasions, you may observe a negative liabilities. Technically speaking, a negative liability is an asset. Negative liabilities frequently appear on accounts payable registered as credits, but it should be classified as prepaid expenses.

Classification of Liabilities

There are two main types of liabilities:

  • Current liabilities (short-term liabilities)
  • Non-current liabilities (long-term liabilities)

Some sources also mention “contingent liabilities” which are those that may or may not occur, for instance, lawsuits or product warranties.

Current liabilities include:

  • Accounts payable
  • Bills payable
  • Interest payable
  • Income taxes payable
  • Bank account overdrafts
  • Accrued expenses
  • Short-term loans

These short-term liabilities have to be paid within one year or less.

Non-current liabilities consist of:

  • Long-term notes payable
  • Bonds payable
  • Deferred tax liabilities
  • Mortgage payable
  • Capital leases

These long-term liabilities have to be paid within longer time periods.

Understanding Liabilities

While assets and net owner’s equity are understood as something positive and good in a very basic sense, liabilities are seen as something negative. Liabilities mean everything that a company has to give out to somebody, so it’s not what the company has but what other entities will get from this company at some point in the future.

Liabilities cause some confusion because accounting doesn’t always work in the same way as plain old mathematics that we learned in school. When doing math, you would expect that an asset is a positive thing that you add up to the total amount, but if your firm owes someone money, intuitively you may think that those liabilities have to be subtracted, so you’d get a positive total capital. It’s partially true when it comes to the formula of the net owner’s equity, but liabilities are also added up the same way as assets when you record them, so this causes some misunderstanding among students who learn basic accounting. When you think about the company’s balance sheet it’s often better to imagine it as two baskets where you put some items, rather that one basket where you put assets and take out liabilities.

Almost any small, mid-sized, and, especially, large company has certain liabilities. It’s quite rare not to see any liabilities in a company’s balance sheet because almost any kind of business needs to borrow money for its operations. Even if a firm is profitable and there is no need to borrow, some corporations will borrow money anyway in order to build up a good credit history in case they would need to borrow later.

In fundamental analysis, it’s essential to do a thorough research of the liabilities because if a company has too many of them, it’s always a bad sign pointing at possible problems with company’s financial health. A number of metrics can be used for such an analysis, for example: the current ratio, the quick ratio, etc.

It’s not that hard to understand that a loan or a debt is a liability, but accounts payable sometimes cause some confusion in the same way as accounts receivable cause misunderstanding in the assets part of the balance sheet. Accounts payable is the amount of money that a company should pay to its customers, suppliers, vendors or government entities at a latter date. Imagine that Apple just received a newly manufactured iPhones from China, the product is already delivered and probably is recorded as assets, but Apple didn’t pay its suppliers yet, so the price of the manufactured product will be temporarily recorded as accounts payable. When the time to pay comes, an amount will be subtracted from accounts payable as well as the same amount for cash resulting in zero-sum settlement.

Liabilities doesn’t always mean loans and debts, they are financial obligations and delayed payments that a company has to finalize at some point. Until this moment, those obligations are recorded as the company’s liabilities.

Another interesting example that illustrates the logic of liabilities is so-called deferred revenue.

Deferred revenue (aka unearned revenue, or unearned income) is a liability that deserves some clarification. A case when such a liability may occur would be when a company received a payment of $1,000 from a customer for a 1-year service, but at the moment, only 6 months have passed, so the customer haven’t used the service during the full paid period. Therefore, a company owes the customer half of his payment ($500) and when the paid period is over, the company will transfer the remaining $500 from the deferred revenue liability to its income, signifying that the obligation of 6 months of service has been fulfilled. This is done because a customer may cancel the subscription and a company would have to return him a certain amount of money, therefore it’s a liability.

List of Liabilities

Here are the typical examples of liabilities that you might find in companies' balance sheets:

  • Accounts payable
  • Bills payable
  • Interest payable
  • Income taxes payable
  • Bank account overdrafts
  • Accrued expenses
  • Short-term loans
  • Long-term notes payable
  • Bonds payable
  • Deferred tax liabilities
  • Mortgage payable
  • Capital leases

Commonly, a firm would have just a few liabilities from the list above, and in some cases, those liabilities can have slightly different names depending on the company’s policies, procedures, government requirements, and the nature of its operations.

Real-life Example of Liabilities

As with our assets example, let’s open the real balance sheet of Apple company to check how they record their financial liabilities. We’ll be looking at Apple’s annual 10-K report for 2019 that can be found here.

➤ Read also: How to Read an Annual Report?

Go to the “Financial Statements” (item 8) and open the “Consolidated Balance Sheets” on page 34.

Apple has just a few types of liabilities listed (in millions of U.S. dollars):

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Apple’s liabilities are totaling 248,028 as of 2019, but what does this number tell us? To understand liabilities we have to know the company’s assets as well, which are equal to 338,516 for the same period, so the net owner’s equity would be 90,488.

As you can see, Apple’s annual report is quite clear and easy to understand, which might not always be the case when you analyze such a report. Note that it’s common for a company to allocate a significant portion of liabilities (and assets too) in the “others” section. Companies do that because the balance sheet is a formalized document that should have specific entries, a company can’t report a type of liabilities that an outsider wouldn’t understand. However, within the company, there might be many specific types of entries which general public doesn’t have to know about, but in the final public report these things are recorded just as “others”. If an investor is interested to see the exact structure of those “other” assets or liabilities, they usually can be found in a different part of the report.

Note that Apple has the same liability “term debt” in both current and non-current sections because some of those liabilities are due to be paid soon (one year or less) and others have to paid later.

Liabilities in Personal Finance

Liabilities are not always about firms, companies, business, and corporations. They also apply to personal finance as well. Any kind of debt or a loan is someone’s liability until the moment it’s fully paid. So, a mortgage, a credit card debt or any other kind of loan is recorded as a liability in a person’s bank statement. Thus, understanding what liabilities are and how they function is important not only for an accountant with a financial degree but for literally anybody who lives in the modern world and use money. Sadly, the general public has a very vague understanding of liabilities and personal finance in general.

Accounting   Business   Capital   Debt   Economics   Finance   Fundamental Analysis   Investing   Liabilities   Microeconomics   Personal Finance   Portfolio

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