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AA Liabilities

Liabilities are obligations owed by a company to creditors from past transactions. They represent claims against a company's assets by creditors and owners. Common liability accounts include accounts payable, notes payable, wages payable, and unearned revenues. Liabilities are classified on the balance sheet as either current or long-term. Commitments and contingent liabilities may exist but are not recorded as liabilities until certain criteria are met, which is often disclosed in the notes to the financial statements.

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61 views2 pages

AA Liabilities

Liabilities are obligations owed by a company to creditors from past transactions. They represent claims against a company's assets by creditors and owners. Common liability accounts include accounts payable, notes payable, wages payable, and unearned revenues. Liabilities are classified on the balance sheet as either current or long-term. Commitments and contingent liabilities may exist but are not recorded as liabilities until certain criteria are met, which is often disclosed in the notes to the financial statements.

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Joresol Alorro
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© © All Rights Reserved
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Liabilities

Liabilities are obligations of the company; they are amounts owed to creditors for a past transaction
and they usually have the word "payable" in their account title. Along with owner's equity, liabilities
can be thought of as a source of the company's assets. They can also be thought of as a
claim against a company's assets. For example, a company's balance sheet reports assets of
$100,000 and Accounts Payable of $40,000 and owner's equity of $60,000. The source of the
company's assets are creditors/suppliers for $40,000 and the owners for $60,000. The
creditors/suppliers have a claim against the company's assets and the owner can claim what
remains after the Accounts Payable have been paid.
Liabilities also include amounts received in advance for future services. Since the amount received
(recorded as the asset Cash) has not yet been earned, the company defers the reporting
of revenues and instead reports a liability such as Unearned Revenues or Customer Deposits. (For a
further discussion on deferred revenues/prepayments see the Explanation of Adjusting Entries.)
Examples of liability accounts reported on a company's balance sheet include:

 Notes Payable
 Accounts Payable
 Salaries Payable
 Wages Payable
 Interest Payable
 Other Accrued Expenses Payable
 Income Taxes Payable
 Customer Deposits
 Warranty Liability
 Lawsuits Payable
 Unearned Revenues
 Bonds Payable
Liability accounts will normally have credit balances.

Contra liabilities are liability accounts with debit balances. (A debit balance in a liability account is
contrary—or contra—to a liability account's usual credit balance.) Examples of contra liability
accounts include:
 Discount on Notes Payable
 Discount on Bonds Payable
 Debt Issue Costs
 Bond Issue Costs

Classifications Of Liabilities On The Balance Sheet


Liability and contra liability accounts are usually classified (put into distinct groupings, categories, or
classifications) on the balance sheet. The liability classifications and their order of appearance on the
balance sheet are:
 Current Liabilities
 Long Term Liabilities
To see how various liability accounts are placed within these classifications, click here to view the
sample balance sheet in Part 4.

Commitments
A company's commitments (such as signing a contract to obtain future services or to purchase
goods) may be legally binding, but they are not considered a liability on the balance sheet until some
services or goods have been received. Commitments (if significant in amount) should be disclosed in
the notes to the balance sheet.

Form vs. Substance


The leasing of a certain asset may—on the surface—appear to be a rental of the asset, but in
substance it may involve a binding agreement to purchase the asset and to finance it through
monthly payments. Accountants must look past the form and focus on the substance of the
transaction. If, in substance, a lease is an agreement to purchase an asset and to create a note
payable, the accounting rules require that the asset and the liability be reported in the accounts and
on the balance sheet.

Contingent Liabilities
Three examples of contingent liabilities include warranty of a company's products, the guarantee of
another party's loan, and lawsuits filed against a company. Contingent liabilities are potential
liabilities. Because they are dependent upon some future event occurring or not occurring, they may
or may not become actual liabilities.

To illustrate this, let's assume that a company is sued for $100,000 by a former employee who
claims he was wrongfully terminated. Does the company have a liability of $100,000? It depends. If
the company was justified in the termination of the employee and has documentation and witnesses
to support its action, this might be considered a frivolous lawsuit and there may be no liability. On the
other hand, if the company was not justified in the termination and it is clear that the company acted
improperly, the company will likely have an income statement loss and a balance sheet liability.
The accounting rules for these contingencies are as follows: If the contingent loss
is probable and the amount of the loss can be estimated, the company needs to record a liability on its
balance sheet and a loss on its income statement. If the contingent loss is remote, no liability or loss
is recorded and there is no need to include this in the notes to the financial statements. If the
contingent loss lies somewhere in between, it should be disclosed in the notes to the financial
statements.

Current vs. Long-term Liabilities


If a company has a loan payable that requires it to make monthly payments for several years, only
the principal due in the next twelve months should be reported on the balance sheet as a current
liability. The remaining principal amount should be reported as a long-term liability. The interest on
the loan that pertains to the future is not recorded on the balance sheet; only unpaid interest up to
the date of the balance sheet is reported as a liability.

Notes to the Financial Statements


As the above discussion indicates, the notes to the financial statements can reveal important
information that should not be overlooked when reading a company's balance sheet.

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