What is a Liability?
How Does a Liability Work?
For example, let's assume that XYZ Company sold $1,000,000 of gift certificates during the holidays. The gift certificates entitle the holders to $1,000,000 of merchandise, and XYZ Company must therefore record a liability for this merchandise. As the gift certificates are redeemed, the company reduces the liability.
Some liabilities are contingent upon the occurrence of other events. For example, XYZ Company may agree to repay the debts of a key supplier if the supplier is unable to do so. This represents a contingent liability for XYZ Company, because it is only liable for the debt if the supplier defaults first. Possible requirements to remedy environmental damage or concerns over the outcomes of some lawsuits are also common types of contingent liabilities.
Accounting liabilities due within one year are generally classified as current liabilities on a company's balance sheet. Liabilities due in more than one year are considered long-term liabilities. It is important to note that although debt commonly comes to mind when one considers liabilities, not all liabilities are debt. Companies may incur several other types of liabilities, including (but not limited to) upcoming payroll, bonuses, legal settlements, payments to vendors, certain derivatives, contracts, certain types of leases, and required stock redemptions. Common balance-sheet categories for liabilities include accounts payable, accrued expenses, and debt.
In business law, liability refers to the responsibility for a company's debt or other obligations. Some forms of business organization, such as a sole proprietorship, have unlimited liability, meaning that the owner is personally responsible for the debts and obligations of the business, and lenders or courts may look to the owner's personal assets for payment of these obligations. Limited liability organizations, such as corporations, allow lenders and courts to only seize the assets of the business rather than the assets of the owners.
Why Does a Liability Matter?
Information about a company's liabilities is a key component of accurate financial reporting and a crucial part of thorough financial analysis. Although the Financial Accounting Standards Board, the Securities and Exchange Commission, and other regulatory bodies define how and when a company's liabilities are reported, and although liabilities make up a significant portion of the balance sheet, not all liabilities are required to appear on the balance sheet. Therefore, analysts must also carefully study the notes to a company's financial statements.
Excessive liabilities can ruin a company, but they are not always detrimental. Liabilities often represent the company's ability to defer cash outlays, allowing it to use that cash for other, possibly more profitable purposes until the obligation is due. The use of debt financing can magnify profits that would have otherwise gone unrealized.
For more detail about how the Financial Accounting Standards Board defines and governs accounting for liabilities, go to http://www.fasb.org/pdf/con6.pdf.