As noted in “FASB Definitions of Assets, Liabilities, and Owners’ Equity” in the section Definitions of Assets, Liabilities, and Owners’ Equity,, liabilities represent “probable future sacrifices of economic benefits” that are the result of past transactions or events. Many times they entail cash payments to other entities, such as repayment to lenders of amounts that have been previously borrowed. The concept of a liability is somewhat broader than this. Liabilities include any probable obligation that the firm has incurred as a consequence of its past activities. For example, many firms warranty their products and consequently are obliged to perform repairs or pay refunds when defects are later uncovered, so, as you can see, not all liabilities require that the firm repay specific dollar amounts on specified dates. Moreover, some liabilities require estimation and judgment in order to determine their amounts. All liabilities, however, have a common characteristic: They represent probable future economic sacrifices by the firm.
Just as with assets, liabilities are classified into two overall categories: current liabilities and noncurrent liabilities. The distinction is based on the length of time before the liability is expected to be repaid or otherwise satisfied by the firm and on whether payment will require the use of assets that are classified as current. Current liabilities are short-term obligations that are expected to utilize cash or other current assets within a year or an operating cycle, whichever is longer. Noncurrent liabilities represent obligations that generally require payment over periods longer than a year.
Accounts payable usually represents debts that the firm incurs in purchasing inventories and supplies for manufacturing or resale purposes. Accounts payable also includes amounts that the firm owes for other services used in its operations, such as rentals, insurance, utilities, and so on. Accounts payable are often called trade debt because they represent debt that occurs in the normal course of any trade or business. (For detailed leassons on Accounts Payable refer Chapter “Current Liabilities”)
Notes payable, are more formal current liabilities than the accounts payable. A note may be signed on the borrowing of cash from a local bank. The note represents a legal document that a court can force the firm to satisfy. (Detailed information on Notes payable is further discussed in the section “Notes Payable”)
Warranty obligations represent the firm’s estimated future costs to fulfill its obligations for repair or refund guarantees. These obligations refer to any products sold or services provided prior to the balance sheet date. Unlike accounts and notes payable, the exact amount of the firm’s obligations for warranties cannot be determined by referring to purchase documents, formal contracts, or similar evidence. Instead, the amount reported for the warranty obligation is based on management’s judgment about future claims for repairs and refunds that may arise from past sales. The amount reported is an estimate, based in part on the past experience of the firm and its competitors. Recall that the FASB defines liabilities in terms of “probable future economic sacrifices”. If Sample Company’s products have required warranty repairs in the past, then it is probable that items sold recently will also require warranty repairs in the future. Because the sales have already occurred, the obligation exists at the balance sheet date, and these estimated amounts must be reported as liabilities.
The next item listed among Sample Company’s current liabilities is accrued expenses, which represent liabilities for services already consumed but not yet paid for or included elsewhere in liabilities. These accrued liabilities usually constitute only a minor part of current liabilities.
Taxes payable comprise the final account listed among the current liabilities of Sample Company. Taxes payable represents unpaid taxes that are owed to the government and will be paid within a year. Taxes payable may include employee withholding taxes, unemployment taxes, employer income taxes, or any number of other taxes that are incurred in the normal course of operations. Taxes payable are typically a relatively minor portion of current liabilities because governmental units require that taxes be paid on a timely basis.
The current liabilities of Sample Company are a representative sample of many short-term liabilities. Businesses engage in many credit-based transactions; most sales to businesses involve accounts receivable, and most purchases by businesses correspondingly involve accounts payable. As a result, the largest of the current liabilities usually consists of trade accounts payable. The other liability items, although less significant in dollar amount, also represent common business transactions and circumstances.
Noncurrent liabilities generally have longer maturities than the current liabilities discussed in the preceding section. Their maturity date is more than one year. Most noncurrent liabilities represent contracts to repay debts at specified future dates. In addition, these borrowing agreements often place some restrictions on the activities of the firm until the debt is fully repaid. In Chapter, “Noncurrent Liabilities,” we discuss a variety of different borrowing arrangements that are widely used.
Bonds payable are a major source of funds for larger business firms. They represent liabilities that the firm incurs by selling a contract called a bond. A bond contains the firm’s promise to pay interest periodically (usually every six months) and to repay the money originally borrowed (principal) when the bond matures. The amount of money that the firm receives from investors for its bonds depends on investors’ views about the riskiness of the firm and the prevailing rate of interest. Investors rely on the ability of the firm to generate sufficient cash flows from its operations to meet the payments as they become due.
Mortgage payable is similar to bonds payable because firms must also make principal and interest payments as they are due. Unlike most bonds, a mortgage represents a pledge of certain assets that will revert to the lender if the debt is not paid. The simplest example of a mortgage is that of a bank holding title to your house until your loan is fully paid. If the loan is not paid, the bank can sell the house and use the proceeds to pay off the debt. Mortgages on factories and hospitals are very similar. The problem in such cases is that there are often very few buyers of specialized assets such as factory buildings and equipment. In such cases, possible mortgage default represents more risk and higher costs to lenders. It also indicates that most lenders will cooperate with borrowers to find alternative solutions to avoid defaults. From an analytical perspective, the analyst or manager must make sure that mortgage terms are being satisfied and that payments have been promptly remitted. For both bonds and mortgages, analysts will try to discern whether cash flows from operations are sufficient to pay the interest and principal.
Liabilities: Summary and Evaluation
Before leaving the liabilities or “borrowed resources” part of the balance sheet, it is useful to summarize various liabilities and to point out some limitations faced by analysts in assessing the firm’s liabilities. Liabilities are classified as either current or noncurrent, based on their maturity dates. The current liabilities of the firm are closely related to its operations. As examples, trade accounts payable arise as a direct consequence of purchasing inventory; accrued expenses and taxes payable result from the firm’s operating and tax expenses; and product warranty obligations occur because the firm has sold products covered by warranties. For this reason, analysts often refer to these types of obligations as spontaneous or operating liabilities.
In contrast, noncurrent liabilities consist mainly of long-term borrowing contracts that managers have negotiated with investors, banks, and other parties. This type of borrowing reflects a deliberate decision by managers to obtain funds from lenders, rather than to obtain additional investments from owners. The decision about how much of the firm’s resources should be provided by long-term borrowing and how much should be invested by owners is a fundamental issue faced by all firms.
Financial statement users are concerned with the firm’s ability to pay both its short-term and long-term obligations as they mature. Later in this chapter, we discuss some ratios that are useful for making these assessments. The analyst is aware of two important features of liability reporting. First, not all liabilities result from promises by the firm to repay specific amounts at determinable future dates. Instead, many liabilities require estimates of future events, such as the warranty obligations reported in Sample Company’s balance sheet. Many other obligations reported by business firms entail similar liability estimates, as we discuss later in Chapter, “Current Liabilities”, and Chapter “Noncurrent Liabilities”.
Second, the analyst is aware that some potential obligations of business firms either are not reported on the balance sheet or are reported at amounts that do not adequately reflect their potential future claims against the assets of the firm. Consider, for example, lawsuits against the firm. At present, tobacco firms are disputing a lengthy list of ailments allegedly associated with cigarette smoking. Similarly, large chemical and nuclear industry firms are being sued over toxic wastes. In these cases, the potential damages awarded to plaintiffs could result in awards of billions of dollars. Although these potentially ruinous lawsuits are based on business activities prior to the current balance sheet date, none of these firms reports significant contingent liabilities because the loss cannot be reliably estimated at this time. Contingent liabilities are discussed further in Chapter, “Current Liabilities”.