Reviewing Liabilities on the Balance Sheet

Michael Schmidt, CFA, is a staff member of FINRA's Dispute Resolution Board with 20+ years of experience in the financial market.

David Kindness is a Certified Public Accountant (CPA) and an expert in the fields of financial accounting, corporate and individual tax planning and preparation, and investing and retirement planning. David has helped thousands of clients improve their accounting and financial systems, create budgets, and minimize their taxes.

Of all the financial statements issued by companies, the balance sheet is one of the most effective tools in evaluating financial health at a specific point in time. Consider it a financial snapshot that can be used for forward or backward comparisons. The simplicity of its design makes it easy to view the balances of the three major components with company assets on one side, and liabilities and owners' equity on the other side. Shareholders' equity is the net balance between total assets minus all liabilities and represents shareholders' claims to the company at any given time.

Assets are listed by their liquidity or how soon they could be converted into cash. Liabilities are sorted by how soon they are to be paid. Balance sheet critics point out its use of book values versus market values, which can be under or over-inflated. These variances are explained in reports like “statements of financial condition” and footnotes, so it's wise to dig beyond a simple balance sheet.

Key Takeaways

• The balance sheet is a financial statement that provides a snapshot of what a company owns and owes, as well as the amount invested by shareholders. It's one of the most effective tools for evaluating the financial health of a business.
• The company's assets are listed on the left side of the balance sheet, while liabilities and shareholders' equity are listed on the right side.
• Liability is an obligation between one party and another not yet completed or paid for in full.
• Short-term liabilities are those expected to be concluded in 12 months or less. They include wages payable, interest payable, and dividends payable.
• Long-term are those expected to be concluded in more than 12 months. They include warranty liabilities and lawsuit payables.

Liabilities

In general, a liability is an obligation between one party and another not yet completed or paid for in full. In the world of accounting, a financial liability is also an obligation but is more defined by previous business transactions, events, sales, exchange of assets or services, or anything that would provide economic benefit at a later date.

Liabilities are usually considered short-term (expected to be concluded in 12 months or less) or long-term (12 months or greater). They are also known as current or non-current depending on the context.

Liabilities can include:

• A future service owed to others
• Short- or long-term borrowing from banks, individuals, or other entities
• A previous transaction that created an unsettled obligation

The most common liabilities are usually the largest like accounts payable and bonds payable. Most companies will have these two line items on their balance sheet, as they are part of ongoing current and long-term operations.

Current Liabilities

Using the AT&T (NYSE: (T) balance sheet as of Dec. 31, 2012, current/short-term liabilities are segregated from long-term/non-current liabilities on the balance sheet. AT&T clearly defines its bank debt as maturing in less than one year. For a company this size, this is often used as operating capital for day-to-day operations rather than funding larger items, which would be better suited using long-term debt. Like most assets, liabilities are carried at cost, not market value, and under GAAP rules can be listed in order of preference as long as they are categorized. The AT&T example has a relatively high debt level under current liabilities. With smaller companies, other line items like accounts payable (AP) and various future liabilities like payroll, taxes, and ongoing expenses for an active company carry a higher proportion.

AP typically carries the largest balances, as they encompass the day-to-day operations. AP can include services, raw materials, office supplies or any other categories of products and services where no promissory note is issued. Since most companies do not pay for goods and services as they are acquired, AP is equivalent to a stack of bills waiting to be paid.

Examples of Common Current Liabilities

• Wages Payable: The total amount of accrued income employees have earned but not yet received. Since most companies pay their employees every two weeks, this liability changes often.
• Interest Payable: Companies, just like individuals, often use credit to purchase goods and services to finance over short time periods. This represents the interest on those short-term credit purchases to be paid.
• Dividends Payable: For companies that have issued stock to investors and pay a dividend, this represents the amount owed to shareholders after the dividend was declared. This period is around two weeks, so this liability usually pops up four times per year until the dividend is paid.

Current Liabilities Off the Beaten Path

• Unearned Revenues: This is a company's liability to deliver goods and/or services at a future date after being paid in advance. This amount will be reduced in the future with an offsetting entry once the product or service is delivered.
• Liabilities of Discontinued Operations: This is a unique liability that most people glance over but should scrutinize more closely. Companies are required to account for the financial impact of an operation, division, entity, etc. that is currently being held for sale or has been recently sold. This also includes the financial impact of a product line that is or has recently been shut down. Since most companies do not report line items for individual entities or products, this entry points out the implications in aggregate. As there are estimates used in some of the calculations, this can carry significant weight. A good example is a large technology company that has released what it considered to be a world-changing product line, only to see it flop when it hit the market. All the R&D, marketing, and product release costs need to be accounted for under this section.

Non-Current Liabilities

Considering the name, it’s quite obvious that any liability that is not current falls under non-current liabilities expected to be paid in 12 months or more. Referring again to the AT&T example, there are more items than your garden variety company may list one or two items. Long-term debt, also known as bonds payable, is usually the largest liability and is at the top of the list. Companies of all sizes finance part of their ongoing long-term operations by issuing bonds that are essentially loans to each party that purchases the bonds. This line item is in constant flux as bonds are issued, mature, or are called back by the issuer.

Examples of Common Non-Current Liabilities

• Warranty Liability: Some liabilities are not as exact as AP and have to be estimated. It’s the estimated amount of time and money that may be spent repairing products upon the agreement of a warranty. This is a common liability in the automotive industry, as most cars have long-term warranties that can be costly.
• Lawsuit Payable: This is another liability that is estimated and requires more scrutiny. If a lawsuit is considered probable and predictable, an estimated cost of all court, attorney, and settled fees will be recorded. These are common line items for pharmaceutical and medical manufacturers.

Non-Current Liabilities Off the Beaten Path

• Deferred Credits: This is a broad category that may be recorded as current or non-current depending on the specifics of the transactions. These credits are basically revenue collected prior to it being earned and recorded on the income statement. It may include customer advances, deferred revenue, or a transaction where credits are owed but not yet considered revenue. Once the revenue is no longer deferred, this item is reduced by the amount earned and becomes part of the company's revenue stream.
• Post-Employment Benefits: These are benefits an employee or family member may receive upon his/her retirement, which are carried as a long-term liability as it accrues. In the AT&T example, this constitutes one-half of the total non-current total second only to long-term debt. With rapidly rising health care and deferred compensation, this liability is not to be overlooked.
• Unamortized Investment Tax Credits (UITC): This represents the net between an asset's historical cost and the amount that has already been depreciated. The unamortized portion is a liability, but it is only a rough estimate of the asset’s fair market value. For an analyst, this provides some details of how aggressive or conservative a company is with its depreciation methods.

What's the Difference Between Current Liabilities and Non-Current Liabilities?

Current liabilities are due within 12 months or less and are often paid for using current assets. Non-current liabilities are due in more than 12 months and most often include debt repayments and deferred payments.

What Is the Relationship Between Assets, Liabilities, and Shareholder's Equity?

The balance sheet is divided into two parts and it's based on the equation below. According to the simple formula, both parts must equal each other ("balance" each other out):

Assets = Liabilities + Shareholders' Equity

Is Short-Term the Same As Current?

Yes. The term "current" refers to a short-term asset or liability. Short-term assets are those that are held for less than one year. In the case of short-term liabilities, they come due in less than one year.

The Bottom Line

The balance sheet, liabilities, in particular, is often evaluated last as investors focus so much attention on top-line growth like sales revenue. While sales may be the most important feature of a rapidly growing startup technology company, all companies eventually grow into living, breathing complex entities. Balance sheet critics point out that it is only a snapshot in time, and most items are recorded at cost and not market value. But setting those issues aside, a goldmine of information can be uncovered in the balance sheet.

While relative and absolute liabilities vary greatly between companies and industries, liabilities can make or break a company just as easily as a missed earnings report or bad press. As an experienced or new analyst, liabilities tell a deep story of how the company finance, plans, and accounts for money it will need to pay at a future date. Many ratios are pulled from line items of liabilities to assess a company's health at specific points in time.

While accounts payable and bonds payable make up the lion’s share of the balance sheet's liability side, the not-so-common or lesser-known items should be reviewed in depth. For example, the estimated value of warranties payable for an automotive company with a history of making poor-quality cars could be largely over or under-valued. Discontinued operations could reveal a new product line a company has staked its reputation on, which is failing to meet expectations and may cause large losses down the road. The devil is in the details, and liabilities can reveal hidden gems or landmines. It just takes some time to dig for them.