Definition of liability (accounting): A present obligation arising from past events.
What is a liability?
A liability is something a business will need to settle or pay in the future.
A crucial (and often overlooked) aspect of the definition is the phrase ‘arising from past events’.
This means that a future order for stock, or next months payroll, will not be a liability in the present.
- A stock purchase will create a liability when the company has received the stock and has taken ownership.
- A payroll cost only becomes a liability when the employee has provided the service.
- A potential tax fine will become a liability as soon as the tax infringement occurred
- A loan will be classed as a liability as soon as it is drawn down in cash
In summary, it’s not enough to be able to point to a future outflow or cost, there must be a past trigger which causes the liability to be present at the balance sheet date.
Liabilities can take many forms:
- Trade creditors
- Accrued liabilities, aka accruals
- Payroll accrual
- Tax accrual
- Service accruals, e.g. recruitment agency costs
- Goods received not invoiced (GRNI)
How is the word liability used in a sentence?
“Deferred consideration is a long-term liability, therefore a journal should be posted to reclassify it to non-current liabilities.”
“The holding company has gross assets of £230m, together with intercompany liabilities of £240m, resulting in a negative shareholders equity position.”
What else you should know about liabilities?
There are usually split between non-current, and current, on the basis of whether the company expects to settle the liability within 12 months from the balance sheet date.
Where a liability may be partially paid within 12 months (such as a bank loan), the current liability element is presented separately to the non-current element.
Net assets is a term given to total assets minus total liabilities.
How does the definition of liability relate to investing?
Investors who buy shares in individual companies will usually perform a review of the publicly available financial statements to get an understanding of the ‘strength’ of the financial position.
The value of assets and liabilities will be the focus of this aspect of the review.
When reviewing the financial statements, pay attention to the split between short term and long term borrowings.
While the overall size of a companies liabilities can be large, non-current liabilities may have little impact on the companies cash flow for the next few years, depending on the due date, the right for the creditor to demand early repayment, and whether interest is paid in instalments. The devil is in the detail.