Liabilities in Accounting Explained for Dummies

What is a liability?

Simply put, a liability in accounting refers to a financial obligation of a business, meaning the money payable that was borrowed from another entity or person.

Furthermore, liabilities in accounting can also be described in the following terms, namely obligations that:

• refer to any type of borrowing from individuals or financial institutions, such as banks, to enable a business to expand its operations and that are payable in the short (current) or long term,
• are legally binding,
• have materialized from actions or events in the past,
• can be settled through the transfer of money, services, and assets,
• can be used as an alternative to equity as a source of a company’s financing,
• are due at a specified or predetermined date, when a specified event occurs, or on-demand.

International Accounting Standard (IAS) 1 and liabilities

International Accounting Standard (IAS) 1, Presentation of Financial Statements, also deals with liabilities in accounting.

Referring to the objective of financial statements, IAS 1 specifies that ‘the objective of general purpose financial statements is to provide information about the financial position, financial performance, and cash flows of an entity that is useful to a wide range of users in making economic decisions.’ [1]

To satisfy the objective, financial statements report information about an entity’s liabilities, along with its assets, equity, income, and expenses.  The information provided concerning liabilities, along with the other reported information and information in the notes accompanying the financial statements, enables users of financial statements to predict ‘the entity’s future cash flows, and, in particular, their timing and certainty,’ according to IAS 1.9.

The distinction between current and non-current liabilities as described by IAS 1

Normally, an entity, such as a company, is required to separate current and non-current liabilities, as is the case with assets. [IAS 1.61]

Current liabilities

IAS 1.69 categorises a liability as a current liability when:

• it is expected to be settled within the entity’s normal operating cycle
• it is held for the purpose of trading
• it is due to be settled within 12 months
• concerning the liability, the entity does not have the right at the end of the reporting period to postpone settlement beyond 12 months.

In addition, IAS 1 requires that ‘if a liability has become payable on demand because an entity has breached an undertaking under a long-term loan agreement on or before the reporting date, the liability is current, even if the lender has agreed, after the reporting date and before the authorisation of the financial statements for the issue, not to demand payment as a consequence of the breach.’ [IAS 1.74]

Non-current liabilities

All the liabilities that are not classified as current liabilities in IAS 1.69 are considered non-current by IAS 1.69.

Furthermore, IAS 1 explains that ‘when a long-term debt is expected to be refinanced under an existing loan facility, and the entity has the discretion to do so, the debt is classified as non-current, even if the liability would otherwise be due within 12 months.’ [IAS 1.73]

Regarding the situation, if liability has become payable on demand due to an entity’s breach of a long-term loan contract, ‘the liability is classified as non-current if the lender agreed by the reporting date to provide a period of grace ending at least 12 months after the end of the reporting period.’ [IAS 1.75]

More about the difference between current and non-current liabilities

As stated by IAS 1, the liabilities of an entity are classified into two main groups, namely current and non-current liabilities. Non-current liabilities are commonly referred to as long-term liabilities.

The primary basis for the classification of a business’s liabilities is its due date. The classification is crucial to a business’s management of its financial obligations and cash flows.

Current liabilities

Current liabilities comprise liabilities that are due within a year.

Examples of current liabilities are:

• Accounts payable, also known as payables, refer to the money that a business owes to its suppliers of goods and/or services.
• Bank accounts overdrafts occur when a bank allows a business (or individual) to execute financial transactions from the bank account when the balance of the account has dropped below zero.
• Income tax payable is the money owed by a business to a government’s tax collecting authority. In South Africa, SARS (the South African Revenue Service) is mandated to collect taxes for the South African government.
• Interest payable, which is part of the finance charges of a business, refers to interest that has already been incurred but has not been paid yet.
• Accrued liabilities, also known as accrued expenses, are financial obligations that are recognised in the accounting system of a business before they have been paid.
• Customer deposits, refer to deposits received from customers for goods or services before a business has delivered the goods or services in return. Customer deposits can also be classified as non-current liabilities.
• Deferred revenues originate when goods have been ordered and paid for by customers but have not yet been delivered by a business. Deferred revenues can also be categorised as long-term liabilities.
• Short-term loans are payable within a time frame of a year.
• Portions of long-term liabilities that will become due and payable in the next 12 months.

Long-term liabilities (non-current liabilities)

Long-term liabilities include, amongst others, the following liabilities:

• Bonds payable refer to the number of outstanding bonds with a maturity of more than one year that has been issued by an entity. Typically, the face value of an entity’s outstanding bonds is reported on its balance sheet.
• Long-term loans, including mortgages, are reported at face value on a company’s balance sheet.
• Deferred tax liabilities, arising from taxes that are assessed and due in a particular current financial period of which the payments have been extended to future tax years.
• Capital leases occur when a business enters into a long-term lease agreement for, inter alia, equipment. The capital lease amount is reported at the net present value of all future payments of the lease obligation.
• Pension obligations refer to the amounts that a company will eventually pay to its retired employees.
• Deferred revenues – See deferred revenues under current liabilities above.
• Customer deposits – Refer customer deposits under current liabilities above.
• Long-term loans that are payable after 12 months or longer.

Reporting of liabilities in accounting

Liabilities, along with assets and equity, of a business are reported on its balance sheet.

The accounting equation[2] requires that the total amount of a business’s liabilities must equal the difference between the total amount of the assets and the total amount of the owners’ equity.

The accounting equation can be expressed in different ways:

• Liabilities = Assets – Owners’ Equity
• Assets = Liabilities + Owners’ Equity
• Owners’ equity = Assets – Liabilities

Liabilities must be reported in accordance with International Accounting Standard (IAS) 1.

Liabilities are listed on the balance sheet according to their due dates.

Typically, current liabilities are listed first in the liabilities section on the balance sheet, indicating to creditors and investors how much a business is required to pay its creditors during the next financial year.

Long-term liabilities are listed after current liabilities on the balance sheet because they are less crucial to a business’s current cash position. 

What is the difference between a liability and an expense?

As mentioned, liabilities are reported on the balance sheet, referring to money owed by a business to other businesses, individuals, and financial institutions such as banks.

Contrarily, expenses are reported on the income statement of a business, indicating the costs incurred by a business to generate revenue.

Liabilities in accounting ratios[3]

The purpose of accounting ratios, also called financial ratios, is to evaluate the profitability, liquidity, efficiency, debt coverage, and market value of a business by comparing the financial data of two line items in the financial statements of a business.

Information obtained from liabilities reported on the balance sheet is used in liquidity ratios and leverage ratios.

Liquidity ratios

Liquidity ratios are financial measurements that determine a company’s ability to pay back its short-term financial obligations as well as its long-term liabilities. Liquidity ratios comprise the following:

• Current ratio

The current ratio also called the working capital ratio, compares a business’s current assets with its current liabilities, determining a business’s ability to pay back its current (short-term) liabilities with its current assets.

The formula to calculate the current ratio is:

Current ratio = Current Assets/Current liabilities

• Quick ratio

The quick ratio, also known as the acid test ratio, is a financial ratio that indicates whether a business has enough current assets to repay its short-term liabilities when inventory is excluded from its current assets.

Current assets excluding inventory are commonly referred to as quick assets.

Sometimes, prepaid expenses are also excluded from current assets when the quick ratio is calculated.

The formula to calculate the quick ratio is:

Quick ratio = (Current assets – Inventory)/Current liabilities

or,

Quick ratio = (Current assets – Inventory – Prepaid expenses)/Current liabilities

• Cash ratio

The cash ratio indicates whether a company can satisfy its current liabilities by only using its cash and cash equivalents.

The formula to calculate to cash ratio is:

(Cash + Cash Equivalents)/Current liabilities

• Operating cash flow ratio

Operating cash flow (OCF) refers to the amount of cash generated by a business’s general and normal operating activities during a specific period of time.

The operating cash flow of a business is obtained from its statement of cash flows.

The operating cash flow ratio measures how many times a business can repay its current liabilities with the money generated from its operating cash flow during a given time period.

The formula to calculate the operating cash flow ratio is:

Operating cash flow ratio = Operating cash flow/Current liabilities

Leverage ratios

Leverage ratios, also referred to as coverage ratios or debt ratios, are financial ratios that calculate the amount of capital that a business obtains from debt. They also determine a business’s ability to honour its debt obligations and to service other associated costs, such as interest payments.

Leverage ratios include the following:

• Debt ratio

The debt ratio, also known as the debt to asset ratio or the total debt to total assets ratio, indicates what portion or percentage of a business’s assets are financed through its liabilities (debt), current and non-current.

The formula to calculate the debt ratio is:

Debt ratio = Total liabilities/Total assets

• Debt-to-equity ratio

The debt-to-equity ratio compares a company’s total liabilities to its shareholders’ equity, expressing its total liabilities as a percentage of shareholders’ equity.

The formula to calculate the debt-to-equity ratio is:

Debt-to-equity ratio = Total liabilities/Shareholders’ equity

• Interest coverage ratio

The interest coverage ratio, also called the times interest earned ratio, indicates how easily a company can service the interest payments on its debt.

The formula to calculate the interest coverage ratio is:

Interest coverage ratio = Operating income/Interest expenses

Where:

Operating income = earnings before interest and taxes (EBIT). Put differently, operating income refers to the amount of income left after deducting all the direct costs related to a business’s operations as well as the indirect costs from the revenue of sales.

• Debt-service coverage ratio (DSCR)

The DSCR measures how efficiently a business can service all its debt service charges, such as interest.

The formula to calculate the DSCR is:

DSCR = Net operating income/Total debt service charges

[1] Accentuations in quotations from IAS 1 are by the article writer.

[2] See the article, ‘The Accounting Equation Explained for Dummies,’ for more information about the accounting equation.

[3] Refer to the article, ‘Accounting Ratios Explained for Dummies,’ for a detailed explanation of accounting ratios.