The fundamental elements of financial statements are assets and liabilities because all other elements depend on them: Equity is assets minus liabilities; Investments by owners, Distributions to owners, and Comprehensive income and its components-revenues, expenses gains, and losses-are inflows, outflows, or other increases decreases in assets and liabilities. Therefore, knowing what liabilities are and what are not is a must for any accountant.
Through this post, I am going to explore the definition of liabilities. I hope that after reading this post, any accountants will have a solid knowledge when trying to decide if a particular item constitutes a liability. Happy reading!
Many examples of type of definition of liabilities in the accounting literatures, they identified liabilities with amounts or duties owed to other entities, emphasizing the payment or expenditure of assets required of the debtor or owing entity to satisfy the claim. They were definitions that described things that most people could recognize as liabilities because they had experience in their everyday lives as well as in their business activities with obligations to pay debts.
Three definitions of liabilities by the AAA, Robert K. Mautz, and Eric L. Kohler, respectively, are examples of the numerous definitions the FASB considered that had those characteristics:
- AAA: The interests or equities of creditors (a common synonym-phrase of liabilities) are claims against the entity arising from past activities or events which, in the usual case, require for their satisfaction the expenditure of corporate resources.
- Robert K. Mautz: Liabilities are claims against a company, payable in cash, in other assets, or in service, on a fixed or determinable future date.
- Eric L. Kohler: Liabilities are amounts owing by one person (a debtor) to another (a creditor), payable in money, or in goods or services: the consequence of an asset or service received or a loss incurred or accrued …
The FASB also found a second type of definition of liabilities that included obligations but also let in some ultimately un-definable what-you-may-call-its—such as deferred tax charges and credits, deferred losses and gains, and self-insurance reserves—items that are not obligations of an entity but were included in its balance sheet as liabilities “to achieve ‘proper’ matching of costs and revenues” or “to avoid distorting periodic net income”.
Prime examples of the second type of definition were those in APB Statement 4, paragraph 132, which explicitly included what-you-may-call-its in its definitions of assets and liabilities:
Liabilities—economic obligations of an enterprise that are recognized and measured in conformity with generally accepted accounting principles. Liabilities also include certain deferred credits that are not obligations but that are recognized and measured in conformity with generally accepted accounting principles.
This definition was circular and open-ended, however, being determinant of and determined by generally accepted accounting principles and saying in effect that liabilities were whatever the Board said they were.
In trying to use the definitions in APB Statement 4 to set financial accounting standards for research and development expenditures and accruing future losses, Board members found that liabilities defined as fallout from periodic recognition of revenues and expenses were too vague and subjective to be workable. That experience strongly reinforced the conceptual and practical superiority of definitions of liabilities based on resources and obligations that exist in the real world rather than on deferred charges and credits that result only from bookkeeping entries.
APB Statement 4’s definitions proved to be of little help to accountants in deciding whether reserves for self-insurance qualified as liabilities because they permit almost any credit balance to be a liability. They were hardly better than the definitions that they had replaced, which also included what-you-may-call-its and were circular and open-ended in the same ways:
… Thus, the word [“liability”] is used broadly to comprise not only items which constitute liabilities in the popular sense of debts or obligations … but also credit balances to be accounted for which do not involve the debtor and creditor relation. For example, capital stock, deferred credits to income, and surplus are balance-sheet liabilities in that they represent balances to be accounted for by the company; though these are not liabilities in the ordinary sense of debts owed to legal creditors.
Definitions of that kind provide no effective limits or restraints on the matching of costs and revenues and the resulting reported net income. If balance sheets at the beginning and end of a period include credits that are labeled liabilities but that result from bookkeeping entries and are only “balance-sheet liabilities,” the income statement for the period will include components of income that are equally suspect—namely, debits and credits that are labeled revenues, expenses, gains, or losses but that result from the same bookkeeping entries as the what-you-may-call-it’s in the balance sheet. They have resulted not from transactions or other events that occurred during the period but from shifting revenues, expenses, gains, or losses from earlier or later periods to match costs and revenues properly or to avoid distorting reported periodic income.
The objective of financial reporting is to provide information useful in making investment, credit, and similar decisions and that items in financial statements represent things and events in the real-world environment—also constituted significant changes in perceptions of the purpose and nature of financial accounting and reporting.
With time, however, both concepts seem to have been understood reasonably well, their level of acceptance has increased, and active opposition has subsided. In contrast, this third concept—that liabilities are the fundamental elements of financial statements—still is undoubtedly the most controversial, and the most misunderstood and misrepresented, concept in the entire financial accounting conceptual framework.
Solid Definition and Characteristics of Liabilities [Concepts Statement 6]
The definition of liabilities in paragraph 35 of Concepts Statement 6:
Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
Next, paragraph 36 describes the three characteristics that an item must possess to be a liability:
- it embodies a present duty or responsibility to one or more other entities that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand;
- the duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice; and
- the transaction or other event obligating the entity has already happened.
The definition prompts the following questions when trying to decide if a particular item constitutes a liability:
Is there an obligation requiring a future sacrifice of assets? If so, which entity is obligated? What past transaction or event made it a liability of that entity?
To answer those questions, let’s call back and discuss the definition of liabilities provided in the Concepts Statement 6 [FASB] phrase-by-phrase. Read on…
Required Future Sacrifice Of Assets
Liabilities commonly arise as the consequence of financial instruments, contracts, and laws invented to facilitate the functioning of a highly developed economy by permitting delays in payment and delivery in return for interest or other compensation as the price for enduring delay. Entities routinely incur liabilities to acquire the funds, goods, and services they need to operate and just as routinely settle the liabilities they incur, usually by paying cash. For example, borrowing cash results in an obligation to repay the amount borrowed, usually with interest; using employees’ knowledge, skills, time, and effort results in an obligation to pay compensation for their use; or selling products with warranties results in an obligation to pay cash or to repair or replace the products that prove defective. Liabilities come in a vast array of forms, but they all entail a present obligation requiring a nondiscretionary future sacrifice of some economic benefit:
The essence of a liability is a duty or requirement to sacrifice assets in the future. A liability requires an entity to transfer assets, provide services, or otherwise expend assets to satisfy a responsibility to one or more other entities that it has incurred or that has been imposed on it [Concepts Statement 6, paragraph 193].
Although most liabilities arise from exchanges between entities, most of which are contractual in nature, some obligations are imposed by laws or governmental regulations that require sacrificing assets to comply.
Receipt of proceeds—cash, other assets, or services—without an accompanying cash payment is often evidence that a liability has been incurred, but it is not conclusive evidence. Other transactions and events generate proceeds—cash sales of goods or services or other sales of assets, cash from donors’ contributions, or cash investments by owners—without incurring liabilities. Liabilities can be incurred without any accompanying receipt of proceeds, for example, by imposition of taxes. It is the obligation to sacrifice economic benefits in the future that signifies a liability, not whether proceeds were received by incurring it.
Most liabilities presently included in financial statements qualify as liabilities under the definition because they require a future sacrifice of assets. They include: accounts and notes payable, wages and salaries payable, long-term debt, interest and dividends payable, and obligations to honor warranties and to pay pensions, deferred compensation, and taxes. Subscriptions or rents collected in advance or other “unearned revenues” from deposits and prepayments received for goods or services to be provided are also liabilities because they obligate an entity to provide goods or services to other entities in the future. Those kinds of items sometimes have been referred to as deferred credits or reserves in the accounting literature.
Obligation Of A Particular Entity
To have a liability, an entity must be obligated to sacrifice its assets in the future—that is, it must be bound by a legal, equitable, or constructive duty or responsibility to transfer assets or provide services to one or more other entities [Concepts Statement 6, paragraph 200]
A liability entails an obligation—legal, moral, or ethical—to one or more other entities to convey assets to them or provide them with services in the future. Not all probable future sacrifices of assets are liabilities of an entity. An intent or expectation to enter into a contract or transaction to transfer assets does not constitute a liability until an obligation to another entity is taken on.
The obligation aspect of liabilities is not emphasized as strongly in the definition in the Concepts Statement as it perhaps might have been. The Board became enamored with making the one-sentence definitions of assets and liabilities parallel to accentuate the symmetry between future benefits of assets and future sacrifices of liabilities.
The definition of a liability puts first “future sacrifices of assets” to make it parallel with the asset definition, but it would have been more precise to focus on an entity’s obligation to another entity to transfer assets or to provide services to it in the future. Future sacrifices of assets, after all, are the consequence—not the cause—of an obligation to another entity. Liabilities are present obligations of a particular entity to transfer assets or provide services to other entities in the future requiring probable future sacrifices of economic benefits as a result of past transactions or events.
Some kinds of assets and liabilities are mirror images of one another. Receivables and payables are the most obvious example: Entity X has an asset (a receivable) because Entity Y has a liability (a payable) to transfer an asset (most commonly cash) to Entity X. Unless Entity Y has the liability, Entity X has no asset. Those relationships hold for rights to receive and obligations to pay or deliver cash, goods, or services. In fact, they hold for most contractual relationships involving a right to receive and an obligation to deliver. Receivables and payables cancel each other in national income accounting, for example, leaving land, buildings, equipment, and similar assets as the stock of productive resources of the economy.
Most kinds of assets are not receivables, and a host of assets have no liabilities as mirror images. For example: the benefit from owning a building does not stem from an obligation of another entity to provide the benefit. The building itself confers significant benefits on its owner. The owner may, of course, enhance the benefits from the building by obtaining the right to services provided by others, who incur corresponding obligations, but that is a separate contractual arrangement involving both rights and obligations for the contracting parties.
Consequently, FASB concern with the symmetry between the future benefits of assets and the future sacrifices of liabilities tended to overshadow the obligation to another entity that is the principal distinguishing characteristic of a liability.
The definition of liabilities in Concepts Statements 3 and 6 and the accompanying explanations might well have profited from a brief description such as that in FASB Statement No. 5, Accounting for Contingencies, paragraph 70.
The economic obligations of an enterprise are defined in paragraph 58 of APB Statement No. 4 as “its present responsibilities to transfer economic resources or provide services to other entities in the future”. Two aspects of that definition are especially relevant to accounting for contingencies:
- first, that liabilities are present responsibilities; and
- second, that they are obligations to other entities.
Those notions are supported by other definitions of liabilities in published accounting literature, for example:
- Liabilities are claims of creditors against the enterprise, arising out of past activities, that are to be satisfied by the disbursement or utilization of corporate resources.
- A liability is the result of a transaction of the past, not of the future.
Occurrence Of A Past Transaction or Event
Items become liabilities of an entity as the result of transactions or other events or circumstances that have already occurred. An entity has a liability only if it has a present obligation to transfer assets to another entity. Budgeting the payments required to enact a purchase results neither in acquiring an asset nor in incurring a liability because no transaction or event has yet occurred that gives the entity access to or control of future economic benefits or binds it to transfer assets. Once incurred, a liability remains a liability of an entity until it is satisfied, usually by payment of cash, in another transaction or is otherwise discharged or nullified by another event or circumstance affecting the entity.