Investopedia: What is a 'Liability'?

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Liability
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What is a 'Liability'

A liability is a company's financial debt or obligations that arise during the course of its business operations. Liabilities are settled over time through the transfer of economic benefits including money, goods or services. Recorded on the right side of the balance sheet, liabilities include loans, accounts payable, mortgages, deferred revenues and accrued expenses.

Liabilities are a vital aspect of a company because they are used to finance operations and pay for large expansions. They can also make transactions between businesses more efficient. For example, in most cases, if a wine supplier sells a case of wine to a restaurant, it does not demand payment when it delivers the goods. Rather, it invoices the restaurant for the purchase to streamline the dropoff and make paying easier for the restaurant. The outstanding money that the restaurant owes to its wine supplier is considered a liability. In contrast, the wine supplier considers the money it is owed to be an asset.
Other Definitions of Liability

Generally, liability refers to the state of being responsible for something, and this term can refer to any money or service owed to another party. Tax liability, for example, can refer to the property taxes that a homeowner owes to the municipal government or the income tax he owes to the federal government. Liability may also refer to the legal liability of a business or individual. For example, many businesses take out liability insurance in case a customer or employee sues them for negligence.
Current Versus Long-Term Liabilities

Businesses sort their liabilities into two categories: current and long-term. Current liabilities are debts payable within one year, while long-term liabilities are debts payable over a longer period. For example, if a business takes out a mortgage payable over a 15-year period, that is a long-term liability. However, the mortgage payments that are due during the current year are considered the current portion of long-term debt and are recorded in the short-term liabilities section of the balance sheet.

Ideally, analysts want to see that a company can pay current liabilities, which are due within a year, with cash. Some examples of short-term liabilities include payroll expenses and accounts payable, which includes money owed to vendors, monthly utilities, and similar expenses. In contrast, analysts want to see that long-term liabilities can be paid with assets derived from future earnings or financing transactions. Debt is not the only long-term liability companies incur. Items like rent, deferred taxes, payroll and pension obligations can also be listed under long-term liabilities.
The Relationship Between Liabilities and Assets

Assets are the things a company owns, and they include tangible items such as buildings, machinery, and equipment as well as intangible items such as accounts receivable, patents or intellectual property. If a business subtracts its liabilities from its assets, the difference is its owner's or stockholders' equity. This relationship can be expressed as assets - liabilities = owner's equity. However, in most cases, this equation is commonly presented as liabilities + equity = assets.
What is the Difference Between an Expense and a Liability?

An expense is the cost of operations that a company incurs to generate revenue. Unlike assets and liabilities, expenses are related to revenue, and both are listed on a company's income statement. In short, expenses are used to calculate net income. The equation to calculate net income is revenues minus expenses. For example, if a company has more expenses than revenues for the past three years, it may signal weak financial stability because it has been losing money for those years.

Expenses and liabilities should not be confused with each other. One is listed on a company's balance sheet, and the other is listed on the company's income statement. Expenses are the costs of a company's operation, while liabilities are the obligations and debts a company owes.
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BREAKING DOWN 'Liability'
Long-Term Liabilities
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Video Definition
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Long-term liabilities, in accounting, form part of a section of the balance sheet that lists liabilities not due within the next 12 months including debentures, loans, deferred tax liabilities and pension obligations. The current portion of long-term debt is excluded to provide a more accurate view of a company's current liquidity and the company’s ability to pay current liabilities as they become due. Long-term liabilities are also called long-term debt or noncurrent liabilities.
BREAKING DOWN 'Long-Term Liabilities'
Long-term liabilities are obligations not due within the next 12 months or within the company’s operating cycle if it is longer than one year. A company’s operating cycle is the time it takes an entity to turn inventory into cash.

Exceptions of Long-Term Liability Reporting

An exception to the above two options relates to current liabilities being refinanced into long-term liabilities. If the intent to refinance is present and there is evidence the refinancing has begun, a company may report current liabilities as long-term liabilities for the reasoning that after the refinancing, the obligations are no longer due within 12 months. In addition, a long-term liability that is coming due but has a corresponding long-term investment restricted for the payment of the debt is reported as a long-term liability. The long-term investment must have sufficient funds to cover the debt.
Examples of Long-Term Liabilities

The long-term portion of a bond payable is reported as a long-term liability. Because a bond payable typically covers a long period of time, the majority of a bond payable is long term. The present value of a lease payment that extends past one year is a long-term liability. Deferred tax liabilities typically extend to future tax years, and if this is the case, the tax liabilities are considered a long-term liability. Mortgages, car payments or other loans for machinery, equipment or land are long term except for the next payments to be made in the subsequent 12 months.
Long-Term Liabilities in Ratios

Long-term liabilities are a useful total for management analysis in the application of financial ratios. The debt ratio compares the total liabilities to total assets, although the ratio may be modified to compare the total assets to long-term liabilities only. This ratio is long-term debt to assets. Long-term debt compared to total equity provides insight relating to a company’s financing structure and financial leverage. Long-term debt compared to current liabilities also provides insight regarding the debt structure of an organization.
Other Long-Term Liabilities
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A balance sheet item that includes obligations which are not going to be paid off within the year or operating cycle, but are not included in the "long term liabilities" category. Other long-term liabilities are commonly found directly beneath the long-term liabilities on the balance sheet. They are part of total liabilities, and the entries are deemed to be not important enough to warrant identifying each amount individually.
BREAKING DOWN 'Other Long-Term Liabilities'

Finding what makes up this entry can be difficult, but sometimes it is included in the footnotes as a table - other times, several notes will be given. Other long-term liabilities might include items such as deferred credits, customers deposits or some estimated tax liabilities. Failing to account for other long-term liabilities may make a company look like it has a stronger financial position than it actually does. That is, while its profits may be strong for a given year, it may have to meet its other long-term liabilities in future years, when profits may not be as strong.
Accounting Equation
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The equation that is the foundation of double entry accounting. The accounting equation displays that all assets are either financed by borrowing money or paying with the money of the company's shareholders. Thus, the accounting equation is: Assets = Liabilities + Shareholder Equity. The balance sheet is a complex display of this equation, showing that the total assets of a company are equal to the total of liabilities and shareholder equity.
BREAKING DOWN 'Accounting Equation'
Any purchase or sale by an accounting equity has an equal effect on both sides of the equation, or offsetting effects on the same side of the equation. The accounting equation could also be written as Liabilities = Assets – Shareholder Equity and Shareholder Equity = Assets – Liabilities.

The basic equation shows that a company can fund the purchase of an asset with assets (a $50 purchase of equipment using $50 of cash) or fund it with liabilities or shareholder equity (a $50 purchase of equipment by borrowing $50 or using $50 of retained earnings). In the same vein, liabilities can be paid down with assets, like cash, or by taking on more liabilities, like debt.
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Unlimited Liability
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An unlimited liability business involves joint owners that are equally responsible for debt and liabilities accrued by the business; this liability is not capped and can be paid off through the seizure of owners’ personal assets, making it different from limited liability ventures.

Typically existing in general partnerships and sole proprietorships, unlimited liability indicates that whatever debt accrues within a business – whether the company is unable to repay or defaults on its debt – each of the business’ owners is equally responsible and personal wealth could reasonably be seized to cover the balance owed. For this reason, most companies opt to form as limited partnerships instead of risking personal assets through unlimited liability businesses.
BREAKING DOWN 'Unlimited Liability'
Consider, for example, four individuals, working as partners, each invest $35,000 into the new business they own jointly. Over a one-year period, the company accrues $225,000 in liabilities. If the company cannot repay these debts, or if the company defaults on the debts, all four partners are equally liable for repayment. This means that in addition to the initial investment of $35,000 that each partner made, all four owners would also be required to come up with $56,250 to alleviate $225,000 in debt.

The Foundation of Unlimited Liability

Unlimited liability companies are most typical in jurisdictions where company law is derived from English law. In the United Kingdom specifically, unlimited liability companies are incorporated or formed through registration under the Companies Act of 2006. Other areas where these companies are formed under English law include Australia, New Zealand, Ireland, India and Pakistan.
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