A liability is an obligation to transfer economic benefit as a result of past events.
Importantly, this definition does not take into account the legal position. It reflects the substance of the arrangement rather than the legal form.
Current liabilities represent liabilities that form part of the operating cycle e,g trade payables (trade creditors), or if not part of the operating cycle have a maturity of less than 12 months.
- 1 accrual accounting for current liabilities
- 2 Definition in concept context
- 3 Assessing financing as buyer or seller using financial ratios
- 4 Accounting like considerations for taking on liability to increase finance
accrual accounting for current liabilities
accounting for employee liabilities
- Some employee liabilities are deductions from gross pay, and can be recorded to offset the salary payable liability ( they reduce the salary payable by accumulating other liabilities payable) , against a total periodic (fortnightly/ monthly ) salary expense.
DR CR salary expense A salary payable B superannuation C worker's comp insurance D employee's tax payable E A = B + C + D + E
Common liabilities that fall in this category are the non-expiring ones like superannuation, worker's accident/disability insurance, and pay-as-you-go taxation. Worker's insurance and taxation can be accumulated for lump-sum annual payment .
- Sick leave can be seen as provision type of liability, where an estimate is made based on historical sick leave about amount of total sick leave will be taken in the coming year, and expensed against a provision for sick leave. Since sick leave doesn't accrue from year to year, unused sick leave provision can reduce the next period's sick leave expense ( similar to ageing of accounts receivable bad debts provision ).
Definition in concept context
With respect to the central equation:
- Assets = Liability + Equity
Liability and Asset share similar adjectives of past , present, and future in their definitions:
- Arising out of defined past events
- A present obligation (liability) / right ( asset)
- for the future outflow ( liability) / in flow ( asset) of resources ( being the concrete form of abstract economic benefit )
( Equity is defined as assets less liabilities ).
And they both have the same recognition criteria : probable , and measurable .
These definitions may be changed soon, to emphasise concepts such as "presently enforceable" , "present right of control over resources(asset)/obligation of economic burden(liability)", by some accounting bodies.
- define asset, liability , and equity, in the framework of 3 sentences about past, present and future , using the words resource, economic benefit, right and obligation .
- Discuss the meaning : "the future economic benefit has to be both probable and measurable in order for either an asset or liability to be recognized".
The role of probable in defining provisions and contingent liabilities
Probable is more than 50% likely to occur because there was a past obligating event. The past obligating event defines a future payment event which is
- on a specific date
- on demand from the obligating party
- linked to another obligating event by specific agreement
A contingent liability suffers from recognition criteria failure, it can't be reliably measured, or isn't probable.
Contingent liabilities become provisions , which are recognised liabilities on financial statements, when they become probable and can be reliably estimated ( measured ).
A reliable estimate of economic burden serves as measurability for provisions: e.g. product warranty provision: if minor repairs cost 5% of the total cost and an estimated 5% of products may require minor repairs within 2 years of sale, and major repairs cost 20% and 1% of products may require major repairs in 2 years, then a provision is made for 5% x 5% + 20% x 1% of budgeted total sales (0.25% + 0.2% = a 0.45% of sales amount set aside as credit to warranty provision liability account , and the warranty expense of 0.45% recorded at the start of the same period as the expected sales . On a warranty being claimed, cash in bank is credited and warranty provision debited to settle this instance of liability with economic outflow).
Assessing financing as buyer or seller using financial ratios
The ratios concerned are classed as liquidity ratios and stability ratios.
- the quick ratio - this is current assets except inventory and prepaid assets over current liabilities.
- If inventory and prepaid assets are included, then it is the current ratio.
- quick ratio should be > 0.9 .
- assets = liabilities + equity . Equity / assets = ( assets - liability) / assets = 1 - liability / assets.
- equity / assets = equity ratio.
- liability / assets = debt ratio. < 0.6 ok.
- from above, equity ratio = 1 - liability ratio
- 1/ equity ratio = assets / equity = capitalisation ratio. < 2.5 ok. ( 1/2.5 = 2/5 = 0.4 = acceptable equity ratio threshold).
How to use
- If more than one years balance sheet is available, a company being considered for investment can be assessed by calculating the liquidity and stability ratios ( or quick ratio and capitalisation ratio, to be concrete ).
- the calculation is (current assets total - inventory - pre-paids) divided by current liabilities for each year's balance sheet.
- If the quick ratio is going down and is significantly less than 1, then liquidity might be a future problem and the company might collapse. A quick ratio less than 1 means that if all the current liabilities are demanded, even by collecting all the current receivables and handing over all cash equivalent assets, there will still be remaining current liability.
- If the capitalisation ratio is > 2.5, then
assets / equity > 2.5, (liability + equity) / equity > 2.5 liability/equity + 1 > 2.5,
liability/equity > 1.5
- try to work out if near current liabilities have been hidden in non-current liabilities, or that contingencies exist that would turn non-current liabilities into current liabilities.
Accounting like considerations for taking on liability to increase finance
If assets = liability + equity, and if (big if) more assets can be employed to efficiently increase income, then:
- increase liability - take on long term borrowings (non-current liabilities), which will have periodic interest expense as well as principal repayment at a fixed long-term date.
- increase equity - issue shares in the company, dilute control possibly, with the promise of retaining less profits through dividend payments (public drawings) periodically.
- the risk of increase liability is risk of failure to pay the principal and insolvency. Can liquidity ratios predict this ?
- the risk of issuing equity as shares is the loss of control of the company, with fewer retained profits due to dividend obligations, a drop in market value due to perceived dilution of share value, more mouths to feed and hence decreased EPS (earnings-per-share) for a given profit.
an example concrete problem statement
From the borrowing viewpoint, if a high probable profit is thought to be likely by increasing assets held through financing, then whether it is better to finance by issuing shares, or by increasing long term borrowings. In the first, the downside is dilution of control and dilution of earnings per share, and in the latter, the downside is increased defaulting risk, decreased liquidity ratios.
- given A= assets, L = liabilities , P = gross profit before tax of 't'% and additional interest, S the current issued shares, if an increase in assets 'a' results in a increase in gross profits 'p' ,is it better to increase by 'a' by issuing 's' shares at 'a'/'s' per share, or borrowing 'a' at an annual interest rate of 'i'% , where an annual interest of 'i' % times 'a' will be incurred ?
- in the first , net profit after tax is P + p * (100 - t) % , giving an earnings per share of ( P + p * (100 - t)/100) / (S + s) , and a debt ratio of L / (A + a)
- in the second, net profit after tax and interest is ( P + p (100 - i) / 100 ) * ( 100 - t) / 100 , giving an EPS of (P + p (1 - i/100) * (1-t/100) / S , and a debt ratio of (L + a) / (A + a)
Rough steps in financing:
- budget and forecast increase profit and increase in assets required. May require lots of management accounting.
- Model results of increasing liability , increasing equity or a combination of both, in order to increase assets.
- analyse consequences of possible different actions.
- choose, lead action
- review results and learn
When trying to avoid liability, a company may issue a 1 for x renounceable share issue, and sweeten the decline in EPS for shareholders by offering a discount in market value of the diluting share offerings. This of course brings the market share value down. This really annoys professional brokers as well, because they have to back pedal their BUY recommendation and qualify that growth prospects will suffer a short-term earnings downgrade.
In contrast: Before the recent GFC, many companies were being financed with large borrowings , because earnings were good and banks were happy that companies were keeping up with interest payments as well as growing money on trees to meet the principal payment. No one really wanted earnings-per-share to go down by asking shareholders to pay for growth. But with the onset of stifled cash-flow , it was found that fair value should have been applied to some fake cash equivalents, like sub-prime backed bonds, so the numerator of the quick ratio suddenly dropped for many companies, and financial entities had to sell their investments: non-current liability flicked the contingency switch and became current, increasing the denominator of the quick ratio. The quick ratio went from comfortably above one, to a lot less than one. Growing by debt became corporate criminality in some instances. Debt restructuring can occur, but if this involves the permanent devaluation of investors interests e.g. share revaluation, where secured major investors such as banks are prioritized over unsecured shareholders ( 'the punters') , then either the smaller shareholders have to bear major losses so the major investors will continue lending because their interests are secured, or the major finance investors refuse to continue lending, because they cannot obtain their required degree of security, and the company cannot obtain money to pay current liabilities when they fall due, and the company becomes insolvent.