A liability is a present obligation of an entity to transfer an economic benefit (FASB Concepts Statement No. 8, Chapter 4, Elements of Financial Statements, paragraph E37). Used in the plural, liabilities are the whole class of those obligations as a balance sheet reports them, the block sitting between the assets and the residual left for the owners. Both senses turn on the same thing, something the entity is bound to do as of the reporting date, whether or not any money moves this year.
The Two Characteristics of a Liability
A liability has two essential characteristics: it is a present obligation, and the obligation requires an entity to transfer or otherwise provide economic benefits to others (FASB Concepts Statement No. 8, Chapter 4, paragraph E38).
The word present carries the first one. To have a liability, an entity must have a present obligation, that is, one that exists at the financial statement date. The settlement date of the liability may occur in the future, but the obligation must be present at the financial statement date. Transactions or other events or circumstances expected to occur in the future do not in and of themselves give rise to obligations today (FASB Concepts Statement No. 8, Chapter 4, paragraph E45). A budgeted cost is not a liability, however certain the spending looks.
Being bound is the test rather than being billed. A liability requires that an entity be obligated to perform or act in a certain manner, and in most cases it is apparent that liabilities are legally enforceable, including those arising from binding contracts, agreements, rules, statutes, or other requirements that would be upheld by a judicial system or government (FASB Concepts Statement No. 8, Chapter 4, paragraph E41).
The second characteristic sets what has to move. Many liabilities require an obligated entity to transfer cash or other assets to one or more identified other entities, and an obligation also can be fulfilled, satisfied, or settled in a number of other ways, including by granting a right to use an asset, providing services, replacing that obligation with another obligation, or converting the obligation to equity (FASB Concepts Statement No. 8, Chapter 4, paragraph E55). Cash is the usual settlement, not the definition.
One boundary follows straight from the pair. An obligation of an entity to itself cannot be a liability, and in the absence of external requirements an entity is not obligated to repair the roof of its building or maintain its plant and equipment, so those actions may be wise business moves that the entity can still forgo or defer (FASB Concepts Statement No. 8, Chapter 4, paragraph E43).
Where the Balance Comes From
Most balances in the class arrive through an exchange. Entities routinely incur liabilities in exchange transactions to acquire the funds, goods, and services they need to operate, so borrowing cash obligates an entity to repay the amount borrowed, acquiring assets on credit obligates an entity to pay for the assets, and selling products with a warranty or guarantee obligates an entity to either pay cash or repair or replace any products that prove defective (FASB Concepts Statement No. 8, Chapter 4, paragraph E40).
Some arrive with nothing given in return. Certain obligations require nonreciprocal transfers from an entity to one or more other entities, and such obligations include taxes imposed by governments, donations pledged to charitable entities, and cash dividends declared but not yet paid (FASB Concepts Statement No. 8, Chapter 4, paragraph E44).
A third group rests on nothing written down at all. A constructive obligation is created, inferred, or construed from the facts in a particular situation rather than contracted by agreement with another entity or imposed by government, and an entity may become constructively obligated through customary business practice (FASB Concepts Statement No. 8, Chapter 4, paragraph E50).
The framework’s own illustration is the one that meets a preparer at a client’s year end. An entity’s past behavior also may give rise to a present obligation, and repeated engagement in a certain behavior may obligate the entity to perform or act in a certain way on the basis of that pattern, so the entity may create a constructive obligation to employees for vacation pay or year-end bonuses by paying them every year even though it is not contractually bound to do so and has not announced a policy to do so (FASB Concepts Statement No. 8, Chapter 4, paragraph E51). The concept has to be applied with great care, since overly narrow interpretations tend to exclude significant actual obligations of an entity while too-broad interpretations effectively nullify the definition of liabilities (FASB Concepts Statement No. 8, Chapter 4, paragraph E52).
All three come on the books from the obligating event rather than the payment. Where the obligation has been incurred and only the invoice or the exact amount is missing, the balance goes on the books regardless, because there is nothing uncertain about the fact that those obligations have been incurred (FASB Statement of Financial Accounting Standards No. 5, paragraph 2). Where the obligation itself turns on an uncertain future event, the probable and reasonably estimable test that decides whether it gets recognized is set out in accruals.
Where Liabilities Sit on the Balance Sheet
Liabilities occupy the middle of the sheet. Take them out of assets and what remains is the residual interest, the equity or net assets figure, and that subtraction rearranged is the identity that makes the sheet balance. Accounts in the class carry a normal credit balance, and the rule that decides which side increases which account is in debit vs credit.
The class then splits on when it settles rather than on what it is. Current against noncurrent, the one-year and operating-cycle test behind that split, the filed captions the noncurrent block runs through, and the two reclassifications that move a balance at close are all in long-term liabilities.
A private client’s own sheet shows the same class in far fewer lines. Under the heading Liabilities and Shareholders’ Equity, the corporate balance sheet per books asks for accounts payable, mortgages, notes, bonds payable in less than 1 year, other current liabilities, loans from shareholders, mortgages, notes, bonds payable in 1 year or more, and other liabilities, at lines 16 through 21 (IRS, Form 1120, Schedule L). Loans from shareholders gets a line of its own there, which is where an owner-managed company reports money its shareholder advanced rather than contributed as capital.
What a Liability Is Not
A Tax Liability
Clients use the same word for the tax they owe, and that sense is a statutory amount computed under the tax law and reported on a return, not an element of the balance sheet. The figure and the line that carries it are in tax liability, and the federal income tax version of it is in federal income tax liability.
An Expense
Where a cost is accrued, the expense and the liability are two sides of one entry. The expense reports the cost the period used up and lands on the income statement, while the liability is the balance left on the sheet until the cash settles, which is why paying it later clears the obligation without creating a second cost. The element itself is in expense, and the outlay that may never become an expense at all is in expenditure.
Legal Exposure
Legal liability in the everyday sense means being answerable for something, which is a different sense of the word from the balance sheet line. The framework separates the two directly. A business risk is not a present obligation, though at some point in the future an event may occur that creates a present obligation, and business risks that follow from an entity’s transactions or its operating environment are not liabilities (FASB Concepts Statement No. 8, Chapter 4, paragraphs E47 and E48).
Common Questions
Liabilities are the obligations an entity is presently bound to settle. On a working set of books the familiar ones are supplier invoices in accounts payable, costs incurred and not yet billed in accruals, issued debt in bonds payable, the deferred tax liability that mirrors the balance covered in deferred tax assets, and the obligation owed on retiring a long-lived asset in asset retirement obligation. Wages owed, taxes owed and a deposit taken before the work is delivered belong to the same class.
An asset is a present right of an entity to an economic benefit and a liability is a present obligation of an entity to transfer an economic benefit (FASB Concepts Statement No. 8, Chapter 4, paragraphs E16 and E37). One is a right and the other is an obligation, both of them present at the reporting date, and what is left after the second is deducted from the first is the residual set out in net assets.
No standard fixes a count of three. Reporting splits the class two ways, current and noncurrent, on the settlement test in long-term liabilities, and contingent is the word people add to make a third.
Contingent does not name a third class of reported liability. The term contingent liability has been a source of confusion because it is often thought to refer to circumstances in which the existence of an obligation depends on the occurrence or nonoccurrence of a future event, and absent a present obligation, the occurrence or nonoccurrence of a future event does not by itself give rise to a liability. Some items commonly described as contingent liabilities do satisfy the definition, because the contingency relates to uncertain future events that affect the amount required to settle a present obligation rather than to whether that obligation exists (FASB Concepts Statement No. 8, Chapter 4, paragraph E60). Whether such an item is accrued or only disclosed turns on the test in accruals.
No rule fixes a count of ten either, and the current side is decided by a settlement test rather than by a list, which is the test in long-term liabilities.
A client’s corporate balance sheet per books carries no total current liabilities line at all, so on a return the split has to be read off the individual liability lines rather than lifted from a subtotal (IRS, Form 1120, Schedule L).
Accountably places trained offshore accountants inside US CPA and EA firms, and a firm can put a real block of its own balance sheet work through a trial task before anything client facing depends on it.
