Liability: Definition, Types, Example, and Assets vs. Liabilities

What Is a Liability?

A liability is something that a person or company owes, usually a sum of money. Liabilities are settled over time through the transfer of economic benefits including money, goods, or services. They're recorded on the right side of the balance sheet and include loans, accounts payable, mortgages, deferred revenues, bonds, warranties, and accrued expenses.

Liabilities are the opposite of assets. They refer to things that you owe or have borrowed. Assets are things that you own or are owed.

How Liabilities Work

A liability is generally an obligation between one party and another that's not yet completed or paid. A financial liability is also an obligation in the world of accounting but it's defined more by previous business transactions, events, sales, exchange of assets or services, or anything that would provide economic benefit at a later date.

Liabilities are categorized as current or non-current depending on their temporality. They can include a future service owed to others such as short- or long-term borrowing from banks, individuals, or other entities or a previous transaction that's created an unsettled obligation.

The most common liabilities are usually the largest such as accounts payable and bonds payable. Most companies will have these two-line items on their balance sheets because they're part of ongoing current and long-term operations.

Liabilities are a vital aspect of a company because they're used to finance operations and pay for large expansions. They can also make transactions between businesses more efficient. A wine supplier typically doesn't demand payment when it sells a case of wine to a restaurant and delivers the goods. It invoices the restaurant for the purchase to streamline the drop-off and make paying easier for the restaurant.

The outstanding money that the restaurant owes to its wine supplier is considered a liability. The wine supplier considers the money it is owed to be an asset.

Other Definitions of Liability

Liability generally refers to the state of being responsible for something. The term can refer to any money or service owed to another party. Tax liability can refer to the property taxes that a homeowner owes to the municipal government or the income tax they owe to the federal government. A retailer has a sales tax liability on their books when they collect sales tax from a customer until they remit those funds to the county, city, or state.

Liability can also refer to one's potential damages in a civil lawsuit.

Current vs. Non-Current Liabilities

It's a long-term liability if a business takes out a mortgage that's payable over a 15-year period but the mortgage payments that are due during the current year are the current portion of long-term debt. They're recorded in the short-term liabilities section of the balance sheet.

Current (Near-Term) Liabilities

Analysts ideally want to see that a company can pay current liabilities that are due within a year with cash. Some examples of short-term liabilities include payroll expenses and accounts payable which can include money owed to vendors, monthly utilities, and similar expenses. Other examples include:

• Wages payable: This is the total amount of accrued income that employees have earned but haven't yet received. Many companies pay their employees every two weeks so this liability changes often.
• Interest payable: Companies often use credit to purchase goods and services. This represents the interest on those short-term credit purchases that must be paid.
• Dividends payable: This represents the amount owed to shareholders after a dividend was declared for companies that have issued stock to investors and pay dividends.
• Unearned revenues: This is a company's liability to deliver goods and/or services at a future date after being paid in advance. The amount will be reduced in the future with an offsetting entry when the product or service is delivered.
• Liabilities of discontinued operations: This is a unique liability. Companies are required to account for the financial impact of an operation, division, or entity that's currently being held for sale or has been recently sold. This also includes the financial impact of a product line that has recently been shut down.
  

Non-Current (Long-Term) Liabilities

Any liability that's not near-term falls under non-current liabilities that are expected to be paid in 12 months or more. Long-term debt is also known as bonds payable and it's usually the largest liability and at the top of the list.

Companies of all sizes finance part of their ongoing long-term operations by issuing bonds that are essentially loans from each party that purchases the bonds. This line item is in constant flux as bonds are issued, mature, or called back by the issuer.

Analysts want to see that long-term liabilities can be paid with assets derived from future earnings or financing transactions. Bonds and loans aren't the only long-term liabilities that companies incur. Items like rent, deferred taxes, payroll, and pension obligations can also be listed as long-term liabilities. Other examples include:

• Warranty liability: Some liabilities aren't as exact as AP. They have to be estimated. Warranty liability is the estimated time and money that may be spent repairing products under the agreement of a warranty. It's a common liability in the automotive industry because many cars have long-term warranties that can be costly.
• Contingent liability evaluation: A contingent liability may or may not occur depending on the outcome of an uncertain future event.
• Deferred credits: This is a broad category that can be recorded as current or non-current depending on the specifics of the transaction. These credits are revenue collected before it's recorded as earned on the income statement. They can include customer advances, deferred revenue, or a transaction where credits are owed but not yet considered revenue. This item is reduced by the amount earned and becomes part of the company's revenue stream when the revenue is no longer deferred.
• Post-employment benefits: These are benefits that an employee or family member may receive upon their retirement. They're carried as long-term liabilities as they accrue. This liability isn't to be overlooked with rapidly rising health care and deferred compensation.
• Unamortized investment tax credits (UITC): This represents the net between an asset's historical cost and the amount that's already been depreciated. The unamortized portion is a liability but it's only a rough estimate of the asset’s fair market value. This provides an analyst with some details regarding how aggressive or conservative a company is with its depreciation methods.

Liabilities vs. Assets

Assets are what a company owns or something that's owed to the company. They include tangible items such as buildings, machinery, and equipment as well as intangibles such as accounts receivable, interest owed, patents, or intellectual property.

The difference is its owner's or stockholders' equity if a business subtracts its liabilities from its assets. The relationship can be expressed like this:

$\text{Assets}-\text{Liabilities}=\text{Owner's Equity}$Assets−Liabilities=Owner’s Equity

This accounting equation is commonly presented this way, however:

$\text{Assets} = \text{Liabilities} + \text{Equity}$Assets=Liabilities+Equity

Liabilities vs. Expenses

An expense is the cost of operations that a company incurs to generate revenue. Expenses are related to revenue, unlike assets and liabilities. Both are listed on a company's income statement. Expenses are used to calculate net income. The equation is revenues minus expenses.

Liabilities are listed on a company's balance sheet and expenses are listed on a company's income statement. Expenses are the costs of a company's operation. Liabilities are the obligations and debts that a company owes. Expenses can be paid immediately with cash or the payment could be delayed which would create a liability.

Example of Liabilities

Let's look at a historical example using AT&T's (T) 2020 balance sheet. The current/short-term liabilities are separated from long-term/non-current liabilities.

AT&T clearly defines its bank debt that's maturing in less than one year under current liabilities. This is often used as operating capital for day-to-day operations by a company of this size rather than funding larger items which would be better suited using long-term debt.

Liabilities are carried at cost, not market value, like most assets. They can be listed in order of preference under generally accepted accounting principle (GAAP) rules as long as they're categorized. The AT&T example has a relatively high debt level under current liabilities. Other line items like accounts payable (AP) and various future liabilities like payroll taxes will be higher current debt obligations for smaller companies.

AP typically carries the largest balances because they encompass day-to-day operations. AP can include services, raw materials, office supplies, or any other categories of products and services where no promissory note is issued. Most companies don't pay for goods and services as they're acquired, AP is equivalent to a stack of bills waiting to be paid.

The Bottom Line

A liability is anything you owe to another individual or an entity such as a lender or tax authority. The term can also refer to a legal obligation or an action you’re obligated to take.

Both businesses and individuals can have liabilities. Your loan is a liability if you borrow money to purchase a car. The portion of the vehicle that you’ve already paid for is an asset. Financial liabilities can be either long-term or short-term depending on whether you’ll be paying them off within a year.