A liability is an obligation to convey assets or perform services at some future date. For purposes of balance sheet analysis, it is important to make a distinction between short-term or current liabilities and long-term liabilities.
The Nature of Current Liabilities
Current liabilities include
- Those obligations which will require payment from existing current assets.
- All other obligations that are to be paid from current assets within one year.
Generally, current liabilities arise from day-to-day business operations (i.e., Accounts Payable, Salaries Payable, etc.). Others may result from the need for short-term loans (i.e., Notes Payable) and still others from management-created long-term obligations having a definite relationship to a short-term period (i.e., current maturity values of long-term loans).
Proper recognition and accurate measurement of all current liabilities are necessary in order to avoid overstatement of assets, long-term liabilities or net income (i.e., the entire balance sheet equity section). Further, current and long-term liabilities must be accurately distinguished so that net working capital will be properly stated. Finally, the preparation of meaningful cash budgets requires that a complete record of all current liabilities be kept.
Valuation of Current Liabilities
Current liabilities (i.e., legal debts and obligations) are generally recorded in the accounts and reported in financial statements at face value. In those rare instances where exact amounts are’ not available, estimates are made, to determine the present value of a future outlay; using the discount method described in APB Opinion No. 21, “Interest on Receivable and Payable.”
Four distinct categories can be identified with respect to the element of uncertainty which affects the valuation of these future payments as current liabilities: definitely determinable liabilities, liabilities arising from operating results, estimated liabilities and contingent liabilities.
Definitely Determinable Liabilities
These liabilities generally originate from contracts or legal statutes which fix the amount of the obligation and its due date rather precisely. Therefore, the basic accounting problem is determining that the obligation does in fact exist and that it is properly recorded.
Trade Accounts and Notes Payable: Procedures for handling the recording and control of trade accounts and trade notes payable center around purchase journals, voucher registers, accounts payable ledgers or open invoice files, etc. Generally these records, or any combination- of them, will yield ample evidence as to the existence, amount and due date of unpaid obligations. For statement purposes it is important that particular attention be paid to transactions occurring near the end of one accounting period and the beginning of the next so that the liability for goods received is recorded in the same period as the merchandise is included in inventory.
Loan Obligations: Items of this type include notes and loans payable and any portion of long-term debt that will mature during the coming operating cycle. However, if such portion of long-term debt will not require the use of current funds (such as retirement through the operation of a special-purpose sinking fund), the debt should be reported as non-current with an appropriate note.
According to APB Opinion No. 21, if no interest is explicitly stated’, or if the rate of interest is unreasonably low, then interest must be imputed (that is, it is understood to be included in the total). If adequate interest is not included,
the cost of the asset will be overstated and interest expense understated. The APB opinion does not apply to payables or receivables arising with suppliers or customers in the normal course of business which are due on ordinary trade terms.
Dividends Payable: Dividend obligations are created only by action of a company’s board of directors. The declaration by the board represents a legal Obligation to pay the cash dividend in the amount specified at the specified time. It always creates a current liability. Accumulated but undeclared dividends on cumulative preferred stock create no liability; however, the existence of such accumulated dividends in arrears should be disclosed by footnote.
Accrued Liabilities: Unpaid obligations resulting from contractual commitments (e.g., payrolls) or government legislation (e.g., taxes) are referred to as accrued liabilities or accrued expenses. Taxes are generally material in nature and are usually shown under a separate heading among current liabilities. Some accruals (e.g., accrued interest) are often combined with their respective liabilities, while most others are shown in a combined form under a single heading. Some types of accruals require special attention.
Liabilities Arising From Operating Results
Some liabilities cannot be measured until the results of operations are known. In these cases, the basic accounting problem is estimating appropriate amounts for interim monthly or quarterly statements.
Income Taxes: This liability applies only to corporate, estate and trust income. Earnings from the operation of sole proprietorship and partnerships are treated as personal income of the parties involved, and generally require no
disclosure of a liability.
When a corporate Federal income tax liability is expected to exceed a specified amount, advance payment of that excess amount is required according to established tax law schedules; nonpayment is subject to penalty.
Any liability not covered by the advance payment is due at specified dates in the following taxable year.
This category refers to liabilities which are indeterminate as to amount and due date, but which exist and can be estimated with a reasonable degree of accuracy as long as there is objective evidence on which to base the amount of such obligation. Such liabilities may be either current or long term. The two main groups of estimated liabilities are discussed below.
Liabilities for Premiums and Other Customer Advances: Premium coupons, tokens, tickets, certificates, etc. which entitle the holder to merchandise, cash, or the performance of a service at some future time are considered customer advances. Such obligations should appear as an estimated liability on the balance sheet of the issuing company. As the coupons are redeemed, a debit is made to the estimated liability account with an offsetting credit to either a revenue account (if the redemption value is greater than the cost of the item) or to a premium inventory account (if the redemption value is equal to the cost of the item).
Actual claims are generally a small percentage of the total amount available for redemption. At year end, therefore, the estimated liability for premium claims and/or the estimated amount of forfeited claims must be determined. Forfeited claims are easily calculated when a specified expiration date occurs during the year. However, where claims must be honored indefinitely, both estimates must be based on the company’s past experience. For example, if a company’s records indicate that redemption average 40% of outstanding premium coupons, the estimated liability account must be reduced with an offsetting credit to an income account.
Liabilities Under Guarantees and Warranties. This liability group arises from product sales (e.g., cars, televisions, etc.) or contracts (e.g., rentals where the lessee must restore property to a specified condition on termination). Although such liabilities may originate at the point of sale or as contracts mature and premises are used, it is always necessary to estimate the company’s liability (and make periodic entries debiting an expense account and crediting an account for the estimated liability), even if the account amount must be adjusted once final performance costs are determined.
For tax purposes, these estimates are deductible only when performance costs have been incurred. However, tax considerations in this case should be minimally considered in the preparation of periodic financial statements, since to do otherwise might overstate income and understate liabilities, particularly when such liabilities are material in amount.
Service contracts for major appliances covering specified time periods constitute another aspect of this liability category. In this case, the price of a service contract is treated as deferred revenue which is recorded on a prorated basis over the contract’s life. Estimates of periodic income realized may be based on a company’s past experience.
The term contingent liabilities refer to potential future obligations which may or may not in fact materialize. It is thus distinguished, from estimated liabilities, which do exist but are uncertain as to amount, due date and/or payee.
Typical contingent liabilities
- Pending Lawsuits
- Litigation against a company is carried as a contingent liability until such time as the claim is actually settled (i.e., after all appeals, upon out-of-court agreement). Lawsuits pending as of the balance sheet date are generally included as footnotes without mentioning dollar values.
- When recourse is involved in discounting notes receivable or assigning accounts receivable, the company endorses such debts and may become liable in the event that the original debtor defaults.
- Income Taxes
- In the event that the IRS fails to accept a company’s tax return as submitted and assesses additional taxes, a contingent liability is created pursuant to an audit. Specific disclosure need be made; frequently, however, a footnote noting IRS examination and final determination of tax liability for certain years may be included. Except in cases of fraud or failure to file a tax return, the statute of limitations prevents the IRS from auditing returns more than three years old.
In reporting contingent liabilities, the sole objective is adequate disclosure of such contingency and if determinable, the amount involved. Disclosure in the financial statements may be made by:
- A parenthetical comment following the item heading
- Inclusion of item among liabilities without extending a dollar amount
- Appropriation of retained earnings.
There are two considerations with respect to current liabilities in the balance sheet:
- Listing Order. Current liabilities are generally listed according to amount (largest to smallest), although they may be listed by due dates when differences in maturity are significant. Liquidation priorities (i.e., taxes, wages, etc.) should be ignored in the interest of the going-concern assumption.
- Detail of Disclosure. The kinds of headings’ used under Current Liabilities will depend on the purpose of the balance sheet. The following classification is generally acceptable:
Notes Payable to Banks
Notes Payable to Trade Creditors Accounts Payable to Trade Creditors Other Notes and Accounts Payable Estimated Income Taxes Payable Other Accrued Liabilities Amounts Due to Officers and Employees Other Current Liabilities
Liabilities ‘which will be liquidated by the issuance of capital stock should be included under stockholders’ equity.