A liability is an (existing) obligation towards another party and is reported on a company’s balance sheet, like debts that small businesses owe to another business, organization, vendor, employee, or government agency.. This obligation may consist of paying money, delivering goods or rendering services. Assets, on the other hand, provide a future economic benefit. Oftentimes, liabilities are used to purchase assets since the assets are expected to provide a greater economic return than the liability plus interest cost.
Some Common Examples Or Types Of Liabilities:
- Equipment loan
- Money owed to suppliers (Accounts payable)
- Real estate mortgages
- Accrued expenses (expenses like payroll taxes or sales taxes that owed and recorded in the businesses general ledger but not yet due)
Short-Term Liabilities Vs. Long-Term Liabilities
Liabilities can also be categorized based on their maturity. Current liabilities (sometimes referred to as short-term liabilities) are obligations that are due within one year. Examples of current liabilities include payables such as accounts payable, wages payable, interest payable, and warranty liabilities. Long-term liabilities (or non-current liabilities) are due after one year or longer. Examples of long-term liabilities include notes payable and long-term leases.
Some examples of short-term liabilities:
- Short-term loans
- Accrued expenses like employee wages, payroll taxes, utilities, etc.
- Accounts payable
- Supplies
Some examples of long-term liabilities include:
- Loans with terms of over one year
- Mortgages
Business liabilities can be divided into two categories: definitely determinable liabilities, for which the amount and timing are known (for example, notes payable and dividend payable). With estimated liabilities, on the other hand, there is uncertainty about the amount and/or timing, which therefore need to be estimated. Examples of estimated liabilities – also called provisions – including income taxes payable and warranty liability.
What financial statements do liabilities show up on?
Technically the only financial statement a liability will show up on is a balance sheet, even though the interest expense from the liability will show up on the cash flow statement and income statement. On an important note, the length of maturity of liability should match up with the item being purchased. For example, short-term borrowings should be used for items that should be turned into cash quickly, like working capital or inventory, while long-term liabilities are used to purchase long-term assets like equipment or real estate. It’s typically not wise to purchase items like inventory with long-term debt as you will be paying on that debt for a long time after those current assets are sold.
Warranty Liability
When a firm sells products or renders services with a warranty, the firm has an obligation towards the customer when the warranty is honored. The warranty liability is an estimate of the obligations. Hence, a product warranty for some product is based on expected breakdowns, the probability that the product is returned for repair, and estimates for material and labor needed to repair the product.
The matching principle requires that the expense of providing a warranty needs to be allocated in the period of the sale, at the same time the gain of the sale is recognized. At the time of sale, the firm expenses the expected cost of the warranty, which is added to the warranty liability. When the warranty is honored at a future point in time, no expenses need to be booked as for this purpose; the warranty liability was created. Thus, at the time warranty is honored, the liability is reduced.
Example
The firm sells phones with a one-year warranty. In the current month, the firm has sold 1,000 units. The expected percentage of phones that need to be replaced is 1%. The expected cost of replacement is 20.
The journal entry at the time of sale related to the warranty:
| T-account | Debit | Credit | |
| Warranty expense | 200 | ||
| Warranty liability | 200 |
During the same month, 15 previously sold phones were required to be replaced under the warranty.
The journal entry for the replacements under the warranty:
| T-account | Debit | Credit | |
| Warranty liability | 300 | ||
| Inventory | 300 |
The warranty liability may appear to be too high (or too low) at some point in time. If the liability turns out to be too low, additional expenses need to be booked. (See Dell’s 4.1 million laptop battery recall program, for example.) If the liability is too high, some of the expenses can be reversed.
Example
At the end of the period, the firm has a warranty liability of 100,000. However, the expected cost of honoring warranty is expected to be 60,000. Thus, the liability is overstated by 40,000.
The journal entry to correct the warranty liability:
| T-account | Debit | Credit | |
| Warranty liability | 40,000 | ||
| Warranty expense | 40,000 |
The use of the warranty liability is similar in nature to the allowance for uncollectible accounts expense. The warranty liability is about the risk in the products sold, whereas the allowance for uncollectible accounts is about the risk of non-payment by customers. The main difference between the two is that the warranty liability is a liability, whereas the allowance for uncollectible accounts is a correction on an asset.
Long-Term Liabilities
Long-term liabilities are obligations that are due one year or longer after the end of the period. Since the time value of money can be large, long-term liabilities are often valued at their present value, where current liabilities are at nominal value.
There are two basic rules that are important when dealing with liability accounts that are at present value. First, by the passing of time, the liability grows, which is an interest expense. Second, liabilities are reduced when money is paid.
Example
At the beginning of the year, the firm has loan of 10,000. The interest rate is 5%. At the end of the year, 500 interest is paid.
The journal entry of the interest expense:
| T-account | Debit | Credit | |
| Interest expense | 500 | ||
| Cash | 500 |
Then, the firm decides to sell a machine and use the proceeds of 4,000 to partially pay down the loan.
The journal entry of this payment:
| T-account | Debit | Credit | |
| Note payable | 4,000 | ||
| Cash | 4,000 |
Bonds
Issuing a bond is a way for a company to raise funds. When the bond is issued, the firm receives money from the investors, which in turn become bondholders who will receive interest payments (‘the coupon’), and at maturity, receive the repayment of the principal.
When the firm is issuing a bond, the firm is offering to pay the nominal interest and the nominal amount of the bond. Because of legal proceedings, there is some time lag between deciding on the terms of the bond (which is a binding contract) and the actual bond issue. As market interest rates are changing continuously, it is not possible for the firm to ‘match’ the nominal interest rate with the rate that the market requires. Instead, changes in the market interest rates result in an issue price for the bond that is potentially different than the face value.
When the market requires a higher rate of return than the firm offers, investors will still be interested in buying the bond. However, they will require a discount. Similarly, investors will bid up to and pay a premium when the market interest rate is below the nominal interest rate. Investors will bid a price where they will make their required return, regardless of the terms of the bond.
Example
The firm is issuing 100 bonds, each with a 1,000 face value with a maturity of 5 years and a nominal interest of 8%. On the day the bond issue is settled, investors are willing to pay 102% of the face value, i.e., 1,020 for each bond. The value of 1,020 corresponds with an effective interest rate of 7.5%.
Important: even though the interest payments are based on the nominal interest rate, the interest expense will equal the effective interest rate. When the investor earns the effective interest rate on its investment, the firm must have the same percentage as the effective interest expense as the party on the other side of the same deal.
In summary: when dealing with bonds, there are two percentages. The nominal interest rate determines the interest payments and the effective interest rate, which is the interest expense. These are not the same because although the repayment at maturity is fixed by contract, the money received at the time of issue determines the effective interest rate. Thus, a bond can be issued at the nominal value (at ‘par’), at a premium, or at a discount. The discount/premium is recorded on a contra T-account.
Example (continued)
The firm is issuing 100 bonds, each with a 1,000 face value with a maturity of 5 years and a nominal interest of 8%. On the day the bond issue is settled, investors are willing to pay 102% of the face value, i.e., 1,020 for each bond. The value of 1,020 corresponds with an effective interest rate of 7.5%.
On the day the issue is finalized, the market interest rate that is used to price this bond is 7.5%. Therefore, the bond is issued at a premium.
The value of a single bond is computed by discounting the cash flows (interest payment and repayment at maturity):
| Period | Amount | Discount factor | Present value | |
| 1 | 80 | 1/1.075 | 74.42 | |
| 2 | 80 | 1/1.075^2 | 69.23 | |
| 3 | 80 | 1/1.075^3 | 64.40 | |
| 4 | 80 | 1/1.075^4 | 59.90 | |
| 5 | 1,080 | 1/1.075^5 | 752.28 | |
| _____ | _____ | |||
| 1,400 | 1,020.23 |
Thus, for an investor that is using 7.5% as the interest rate, 74.42 today is equivalent to 80 one year later. Similarly, an investor (using 7.5%) is indifferent between buying the bond for 1,020.23 or not buying the bond.
The total interest expense equals the total interest payments minus a premium or plus a discount. In other words, when a bond is issued at a premium, the premium is a gain for the company because it will only need to repay the nominal value. Similarly, when it is issued at a discount, the discount is an additional expense on top of the interest payments because the firm will need to repay the nominal value (as this is determined by the bond contract). The matching principle requires that the discount/premium be allocated over the bond’s lifetime.
There are two methods to allocate the premium/discount to the duration of the bond: the straight-line method and the effective interest method.
With the straight-line method, the premium/discount is amortized linearly over the duration of the bond.
Example (continued)
The firm is issuing 100 bonds, each with a 1,000 face value with a maturity of 5 years and a nominal interest of 8%. On the day the bond issue is settled, investors are willing to pay 102% of the face value, i.e., $1,020 for each bond. The value of 1,020 corresponds with an effective interest rate of 7.5%.
The journal entry of issuing the bond (numbers are rounded):
| T-account | Debit | Credit | |
| Cash | 102,000 | ||
| Bond payable | 100,000 | ||
| Bond premium | 2,000 |
The yearly journal entry for the interest payment:
| T-account | Debit | Credit | |
| Interest expense | 7,600 | ||
| Bond premium | 400 | ||
| Cash | 8,000 |
*400 = 2,000 / 5 years
When the effective interest method is used, the bond remains valued over the duration of the bond at the present value of the interest payments and repayment at maturity.
It is helpful to make a repayment schedule, to highlight the difference between the interest payment and interest expense over time. The repayment schedule will show for each year the beginning of year present value of the bond, the interest expense (= effective interest rate x beginning of year present value), the interest payment (=nominal interest rate x nominal value), and the end of the period present value of the bond(=beginning value + interest expense – interest payment).
In each period, the interest expense will be less than the interest payment in the case of a premium. Similarly, in the case of a discount, the interest expense will be greater than the interest payment. Regardless of whether there is a premium or discount, all of the premium/discounts will have been allocated at maturity.
Example (continued)
The firm is issuing 100 bonds, each with a 1,000 face value with a maturity of 5 years and a nominal interest of 8%. On the day the bond issue is settled, investors are willing to pay 102% of the face value, i.e., 1,020 for each bond. The value of 1,020 corresponds with an effective interest rate of 7.5%.
The expense is computed as the beginning of year present value multiplied by the effective interest rate. The terms of the bond dictate the interest payments and repayment.
The journal entry of the first year’s interest payment (for the 100 bonds in total):
| T-account | Debit | Credit | |
| Interest expense | 7,652 | ||
| Bond premium | 348 | ||
| Cash | 8,000 |
The journal entry of the last year’s interest payment and repayment of the nominal value:
| T-account | Debit | Credit | |
| Bond | 100,000 | ||
| Interest expense | 7,535 | ||
| Bond premium | 465 | ||
| Cash | 108,000 |
Note that the sum of the total interest expense (379,77) equals the total interest payments (400) minus the premium (20.23), which is received at the time of issue but does not have to be repaid.
When a bond is callable, the firm has the right (not the obligation) to repay the bond at an earlier point in time than the maturity date. This option has value for the firm when interest rates have declined. In this case, the firm can lower its interest expenses by repaying the bond with the proceeds of a new bond. Bondholders, however, will require to be compensated for allowing the firm to have such an option. Therefore, the terms of the bond will include a penalty to be paid by the firm to the bondholders when the firm calls the bond.
Financial Lease
With a lease, a firm uses the asset which (legally) belongs to another party. Accounting-wise, we distinguish between short-term lease, operating lease, and long-term lease, called financial lease (also called finance lease, or capital lease). The primary differentiating factor is that with a financial lease, the risks (and rewards) are with the firm, which is leasing because the lease is long-term and cannot be cancelled.
Application of the ‘substance over form principle, meaning that the economic reality (having the risks and rewards) is more important than the legal reality (not having legal ownership), has resulted in a difference in accounting treatment for operating lease versus financial lease.
With an operating lease, the lease payments are expensed in the period where the asset is used (which is usually the period in which the lease term is paid). With a financial lease, when the contract is signed, the firm recognizes an asset as well as a liability for the present value of the lease payments. The lease terms will include interest and repayment. As the lease terms are paid, interest expense is booked, and the liability is repaid. The asset is depreciated over the economic lifetime.
Example
The firm has entered a long-term lease contract for a machine. The lease term is six years. Annually, the firm will pay 5,000 at the end of each year. The effective interest rate is 7.5%.
The present value of the payments is 23,469.23.
When the contract is signed, the firm makes the following journal entry:
| T-account | Debit | Credit | |
| Machines | 23,469.23 | ||
| Lease obligations | 23,469.23 |
The repayment schedule is as follows:
Liabilities increase with (effective) interest, and are reduced with payments. Thus, the interest expense in the first year is 1,760.19, and the payment is 5,000. Hence, the liability reduces with the difference of 3,239.81.
For the first payment the following journal entry is made:
| T-account | Debit | Credit | |
| Interest expense | 1,760.19 | ||
| Lease obligations | 3,239.81 | ||
| Cash | 5,000 |
Also, the asset is depreciated over its economic lifetime. Using straight line depreciation and assuming no residual value results in a yearly depreciation expense of 23,469.23 divided by six years equals 3,911.54 per year.
| T-account | Debit | Credit | |
| Depreciation expense | 3,911.54 | ||
| Accumulated depreciation machine | 3,911.54 |
Currently, accounting principles have a cut-off point between an operating lease and a financial lease. If the (uncancellable) term is at least 75% of the economic lifetime, the present value of the lease terms at least 90% of the purchase price of the asset, or the lease contract includes a provision by which the asset can be bought at the end of the term for a symbolic amount; then the lease is considered finance lease. However, currently, the FASB and IASB (standard-setting bodies of US GAAP and IFRS, respectively) are working on new accounting regulations where operating lease will be treated as a financial lease. This new regulation is expected to be effective in 2011.
