What is a responsibility?
A liability, in general, is an obligation or something that you duty someone else. Liabilities are defined as the debts or legal financial obligations of a business that arise in the course of its commercial activities. They can be with limited or unlimited liability. Liabilities are settled over time by the transfer of economic benefits, including money, goods or services. Listed on the right side of the balance sheet, liabilities include loans, accounts payable, mortgages, deferred revenue, earned premiums, unearned premiums and accrued liabilities. Even marriages can change your responsibility.
In general, a liability is an obligation between a party and another not yet completed or paid. In the accounting world, a financial liability is also an obligation but is more defined by business transactions, events, sales, exchanges of prior assets or services, or anything that could provide an economic benefit to a later date. Liabilities are generally considered to be short-term (should be concluded in 12 months or less) or long-term (12 months or more).
Liabilities are also called current or non-current depending on the context. They may include future service due to others; short or long term borrowings from banks, individuals or other entities; or a previous transaction that created an unsettled obligation. The most common liabilities are usually the most important, such as accounts payable and payable. Most companies will have these two items on their balance sheets because they are part of current and long-term operations.
What is a responsibility?
Liabilities are an essential aspect of a business because they are used to finance operations and pay for large expansions. They can also make business-to-business transactions more efficient. For example, in most cases, if a wine supplier sells a case of wine to a restaurant, he does not require payment when he delivers the goods. Rather, he invoices the restaurant for the purchase in order to rationalize the deposit and facilitate payment for the restaurant.
The unpaid money that the restaurant owes to its wine supplier is considered a liability. On the other hand, the wine supplier considers the money due to him as an asset.
Other definitions of responsibility
Generally, responsibility refers to the state of being responsible for something, and this term can refer to any money or service owed to another party. Tax liability, for example, can refer to the property taxes an owner owes to municipal government or the income tax he owes to federal government.
Liability can also refer to the legal responsibility of a company or an individual. For example, many companies purchase liability insurance if a customer or employee sues them for negligence.
Current long-term liabilities
Companies classify their liabilities into two categories: short-term and long-term. Current liabilities are debts payable within one year, while long-term liabilities are debts payable over a longer period. For example, if a business contracts a mortgage payable over 15 years, it is a long-term liability. However, mortgage payments that are due in the current year are considered the current portion of long-term debt and are recorded in the short-term liabilities section of the balance sheet.
Ideally, analysts want to see that a company can pay current debts, which are due within a year, with cash. Some examples of short-term liabilities include payroll and accounts payable, which include amounts owed to suppliers, monthly utilities and similar expenses. In contrast, analysts want to see that long-term liabilities can be paid for with assets derived from future profits or financing transactions. Debt is not the only long-term liability company to incur. Items such as rent, deferred taxes, payroll and retirement obligations can also be included in long-term liabilities.
The relationship between liabilities and assets
Assets are the assets that a business owns – or the assets that are owed to it – and they include tangible items such as buildings, machinery and equipment as well as intangibles such as accounts receivable, interest owed , patents or intellectual property.
If a business subtracts its liabilities from its assets, the difference is the equity of its owner or its shareholders. This relationship can be expressed as follows:
However, in most cases, this accounting equation is generally presented as such:
What is the difference between an expense and a responsibility?
An expense is the cost of operations that a business undertakes to generate income. Unlike assets and liabilities, expenses are linked to income, and both are recorded in the company’s income statement. In short, expenses are used to calculate net income. The equation for calculating net income is income minus expenses.
For example, if a business has more expenses than revenues in the past three years, it may signal poor financial stability because it has lost money in those years.
Expenses and responsibilities should not be confused. One is on the balance sheet of a company and the other is on the company’s income statement. Expenses are the costs of operating a business, while liabilities are the obligations and debts that a business owes.
Examples of liabilities
As a practical example of understanding a company’s liabilities, let’s look at a historical example using AT & T’s 2020 balance sheet (NYSE: T).
AT&T 2020 report
Using AT & T’s (NYSE: T) balance sheet as of December 31, 2020, current / short-term liabilities are separated from long-term / non-current liabilities on the balance sheet. AT&T clearly defines its bank debt maturing in less than a year. For a business of this size, it is often used as operating capital for day-to-day operations rather than to finance larger items, which would be better suited using long-term debt.
Like most assets, liabilities are recorded at cost, not market value, and under GAAP rules, they can be ranked in order of preference as long as they are classified. The example of AT&T has a relatively high level of debt for current liabilities. With small businesses, other items such as accounts payable (AP) and various future liabilities such as payroll, taxes and current expenses for an active business have a higher proportion.
AP generally carries the largest balances because they include daily operations. AP may include services, raw materials, office supplies or any other category of products and services for which no promissory notes are issued. Since most businesses do not pay for goods and services as they are acquired, AP is equivalent to a stack of invoices awaiting payment.
Examples of current liabilities
- Fees: The total amount of accumulated income that employees have earned but not yet received. Since most companies pay their employees every two weeks, this responsibility often changes.
- Interest payable: Businesses, like individuals, often use credit to buy goods and services to finance for short periods. This represents the interest on those short-term credit purchases payable.
- Dividends payable: For companies that have issued shares to investors and pay a dividend, this represents the amount due to shareholders after the declaration of the dividend. This period is approximately two weeks, so this liability generally appears four times a year, until the dividend is paid.
Less current liabilities
- Uncollected income: It is the responsibility of the business to deliver goods and / or services at a later date after being paid in advance. This amount will be reduced in the future with a compensatory entry once the product or service has been delivered.
- Liabilities from discontinued operations: This is a unique responsibility that most people can take a look at, but should take a closer look at. Companies must take into account the financial impact of a transaction, division or entity that is currently held for sale or has recently been sold. This also includes the financial impact of a product line that is or has recently been closed.
Since most businesses do not report line items for individual entities or products, this entry highlights the implications as a whole. As some estimates are used in some calculations, this can carry significant weight.
A good example is a large tech company that has released what it sees as a world-changing product line, only to see it flop when it hits the market. All R&D, marketing and product launch costs should be accounted for in this section.
Given the name, it is quite obvious that any non-current liability is one of the non-current liabilities that should be paid in 12 months or more. Referring again to the AT&T example, there are more items than your garden variety company that can list one or two items. Long-term debt, also known as bonds, is usually the biggest liability and tops the list.
Companies of all sizes finance part of their long-term operations by issuing bonds, which are essentially loans to each party buying the bonds. This line is constantly evolving as the bonds are issued, matured or recalled by the issuer.
Examples of current non-current liabilities
- Warranty liability: Some liabilities are not as accurate as AP and need to be estimated. This is the estimated time and money that can be spent repairing products when accepting a warranty. This is a common responsibility in the automotive industry, as most cars have long term warranties which can be costly.
- Legal action to pay: This is another estimated liability that requires further examination. If a lawsuit is considered likely and foreseeable, an estimated cost of all court, attorney and settled costs will be recorded. These are common items for manufacturers of pharmaceutical and medical products.
Less current non-current liabilities
- Deferred credits: It is a broad category that can be recorded as current or non-current depending on the specifics of the transactions. These credits are essentially income received before being earned and recorded in the income statement. It may be advances to customers, deferred revenue or a transaction in which credits are due but are not yet considered revenue. Once revenue is no longer carried forward, this item is reduced by the amount earned and becomes part of the business revenue stream.
- Post-employment benefits: These are benefits that an employee or family members may receive upon retirement, which are recognized as a long-term liability as they accrue. In the AT&T example, this represents half of the total non-current total, just behind the long-term debt. With the rapid increase in health care and deferred compensation, this liability should not be overlooked.
- Undepreciated investment tax credits (UITC): This represents the net between the historical cost of an asset and the amount that has already been written off. The undepreciated portion is a liability, but it is only a rough estimate of the fair market value of the asset. For an analyst, this provides details on the aggressiveness or prudence of a company with its depreciation methods.