Liabilities

Current Liabilities

Accounts Payable

Accounts payable are generally incurred for the purchase of supplies, inventory, materials, services, utilities, etc., and generally due within 30-90 days of incurrence of the obligation. When reviewing accounts payable, some of the key things to pay attention to are the ages of the outstanding payables and the vendor concentration. Are you dealing with a few powerful vendors, or are the company's obligations diffuse and scattered?

A lot can be learned about a company's operations and health by looking over the list of who it owes money to and who it is paying. Is it dependent on key vendors, is it churning vendors due to inabilities to pay, does it have enough market power to be able to stretch its vendors beyond traditional terms, is it constantly taking deductions from payments to vendors? What does it need to buy and how frequently does it replenish?

Accrued Expenses

Accrued expeses are costs that have been incurred, but for which invoices usually are not received (if an invoice had been received, the liability would be an Accounts Payable). Examples of commonly accrued expenses are wages, taxes, commissions, employee vacations, warranty expenses, and interest. In a distressed situation, most of the initial attention is focused on accounts payable, but once a transition to bankruptcy is made, many accrued expense items get a higher priority than the unsecured trade debt does.

Loans and Notes Payable

These are short-term borrowings from banks or other commercial transactions.

Current Portion of Long-term Debt

This refers to the principal payments of longer-term debt instruments that must be paid within the next 12 months (following the date of the balance sheet).

Unearned Revenues

Unearned revenues are payments received by customers for products or services not yet provided, such as subscriptions, retainers, maintenance agreements, and insurance premiums.

Income Tax Payable

This is technically an Accrued Expense, but profitable companies usually show this amount separately. Unprofitable companies do not have to worry about it.

The Importance of Current Liabilities

Current liabilities are an important indicator of the company's financial health. One of the definitions of “insolvency” is “an inability to pay obligations as they come due.” Since the current liabilities are the first obligations to come due, this is one of the first places to look in any solvency evaluation.

Long-Term Liabilities

Long-term Liabilities include the non-current portions of notes payable, bonds payable, and mortgage obligations. When a lease is considered to be a secured financing agreement, these obligations are also treated as long-term liabilities.'

When a company is operating well, long-term creditors seem to have the worst positions of any of the stake holders. They do not get the constant attention (and payments) that short-term creditors receive, and they do not have the upside potential that excites equity holders. Long-term creditors usually take what they hope is minimal risk in exchange for earning a fixed rate of return. As a company spirals deeper and deeper into financial trouble, however, the significance of the long-term creditor usually strengthens, and in extreme situations it is often the long-term creditors that end up owning or deciding the fate of the company.

Deferred Taxes

These are long-term liabilities that arise out of timing differences between GAAP accounting and tax accounting. When Congress has allowed certain tax benefits, such as faster depreciation write-offs for tax purposes than the deciders of GAAP allow, these differences create accelerated expense write-offs and lower (than GAAP) taxable income in early years. The tax deferral is from a GAAP standpoint only ' the company has paid the proper tax according to tax law. The theory is that eventually these timing differences between tax law and GAAP will reverse, and in later years this deferred tax liability will be paid back when GAAP catches up to reality. During the past few years, Congress has been trying to stimulate capital investment, and depreciation allowances have become increasingly accelerated and liberal, which has caused many companies to record larger and larger deferred tax liabilities. If the company continues to grow and replace assets, or if Congress continues to tinker with tax law, or if the company becomes insolvent, these “liabilities” may never actually be “paid back.”

Pension Plan and Retirement

Pension plan and retirement liabilities used to receive little attention, but have been very prominent in the news during the current economic cycle. These obligations were a major component of the General Motors and Chrysler bankruptcies, and so politically sensitive that the government strong-armed secured creditors to elevate these liabilities to a much higher priority than the bankruptcy code typically provides for them. The liability shown on the balance sheet represents the unfunded amount of what an actuary has determined is the company's obligation. Governments, which generally do not follow GAAP, swept these obligations under the rug for a long time and seem to have all suddenly realized that they exist, they are huge, and they need to be dealt with.

Companies often record liabilities in the anticipation of incurring costs. For example, if a company plans a plant closure, the sale of a division at a loss, or a mass layoff, it may record a liability for what it expects the costs of those future actions to be. Some companies recorded huge liabilities when “Obamacare” was passed in 2010, even though the costs of that legislation are not expected to become actual cash outflows until 2014 and beyond. Remember one of the cardinal rules: Debits have to equal credits, and the corollary is that for every debit there is an equal and offsetting credit. The recording of these liabilities has as its equal offset a charge to the income statement that correspondingly reduces reported net income.

Contingent Liabilities

Contingent liabilities may or may not develop into real liabilities, depending on which side has the better lawyer. In addition to lawsuits, contingent liabilities can also arise from warranty obligations, non-compliance with government regulations, accidents, or self-insurance programs. If the impairment of an asset or incurrence of a liability is “probable” and the amount can be “reasonably estimated,” then this will be reflected on the balance sheet and income statement as a known item. If the contingent liability is only “reasonably possible” or the amount cannot be “reasonably estimated,” then the contingency gets disclosed in the footnotes to the financial statements, but does not appear on the financial statements themselves. “Reasonableness” is in the eye of the beholder, or in this case, of the accountant.

Transfer of Non-Current Assets

In the weird and wacky world of accounting, a liability that will be satisfied in the very near future (within 12 months) with the transfer of non-current assets is not considered a current liability. For example, if you had 10 years left on your mortgage, typically the principle that would be paid in the next 12 months is “current,” and the rest of the principle is “long-term.” However, if you were in default and the entire mortgage was subject to acceleration, the entire mortgage would be shown as “current” whether the lender had actually accelerated it or not. On the other hand, if your plan is to satisfy the mortgage in full by giving the building back to the bank, since the building is a fixed asset, none of the mortgage is considered “current.”

Legally Enforceable Debt

The fact that a liability appears on the balance sheet does not mean that it is a legally enforceable debt, or that it will liquidated for the amount shown on the financial statements.' For example, a liability for repairs under warranty is not an actual debt to an actual customer ' it is an estimate based on historical patterns of what product returns may be. At the time warranty costs and liabilities are recorded, it is not known which customers, if any, may be bringing a product back to the company. If product quality has increased or decreased, or customers have gotten more or less finicky, the real obligation for warranty repairs may be significantly less than or greater than what is recorded on the balance sheet.

Similarly, changes in market conditions from what the actuary used in the pension plan assumptions (such as interest rates being 1% instead of 8%) can significantly change the pension liability shown on the balance sheet.

Conclusion

Liabilities are subject to courts, negotiation, commercial practices, and economic reality. The old saying that “nothing is certain except for death and taxes” is for the most part true, except that in today's political environment there is less and less certainty regarding what tax policy will be. Accountants do their best in all this to record and classify liabilities as they expect them to be paid. Some liabilities are more certain than others, but at the end of the day, the only way to truly know what the amount and terms of an obligation were is when the check that satisfies that obligation clears the bank.

Michael Goldman, MBA, CPA, CVA, CFE, CFF, is principal of Michael Goldman and Associates, LLC in Deerfield, IL. His qualifications include Insolvency, Financing, Planning, Turnaround Management and Business Valuation. He may be reached at [email protected].

This article is the seventh installment in an ongoing series focusing on accounting and financial matters for corporate counsel.

Liabilities are what a company owes. They are also the offsetting part of the transactions that are the primary source of cash (the others being profits, equity infusions, or liquidation of assets). Very often, a quick study of the liabilities of a company will tell you much of what you need to know about its operations, health, and financing.

Liabilities are usually listed on the balance sheet in order of when they come due ' the sooner they are due, the higher up they are. They are classified as Current (expected to be paid within one year) or Long-Term (not expected to be liquidated within the next 12 months).

Current Liabilities

Accounts Payable

Accounts payable are generally incurred for the purchase of supplies, inventory, materials, services, utilities, etc., and generally due within 30-90 days of incurrence of the obligation. When reviewing accounts payable, some of the key things to pay attention to are the ages of the outstanding payables and the vendor concentration. Are you dealing with a few powerful vendors, or are the company's obligations diffuse and scattered?

A lot can be learned about a company's operations and health by looking over the list of who it owes money to and who it is paying. Is it dependent on key vendors, is it churning vendors due to inabilities to pay, does it have enough market power to be able to stretch its vendors beyond traditional terms, is it constantly taking deductions from payments to vendors? What does it need to buy and how frequently does it replenish?

Accrued Expenses

Accrued expeses are costs that have been incurred, but for which invoices usually are not received (if an invoice had been received, the liability would be an Accounts Payable). Examples of commonly accrued expenses are wages, taxes, commissions, employee vacations, warranty expenses, and interest. In a distressed situation, most of the initial attention is focused on accounts payable, but once a transition to bankruptcy is made, many accrued expense items get a higher priority than the unsecured trade debt does.

Loans and Notes Payable

These are short-term borrowings from banks or other commercial transactions.

Current Portion of Long-term Debt

This refers to the principal payments of longer-term debt instruments that must be paid within the next 12 months (following the date of the balance sheet).

Unearned Revenues

Unearned revenues are payments received by customers for products or services not yet provided, such as subscriptions, retainers, maintenance agreements, and insurance premiums.

Income Tax Payable

This is technically an Accrued Expense, but profitable companies usually show this amount separately. Unprofitable companies do not have to worry about it.

The Importance of Current Liabilities

Current liabilities are an important indicator of the company's financial health. One of the definitions of “insolvency” is “an inability to pay obligations as they come due.” Since the current liabilities are the first obligations to come due, this is one of the first places to look in any solvency evaluation.

Long-Term Liabilities

Long-term Liabilities include the non-current portions of notes payable, bonds payable, and mortgage obligations. When a lease is considered to be a secured financing agreement, these obligations are also treated as long-term liabilities.'

When a company is operating well, long-term creditors seem to have the worst positions of any of the stake holders. They do not get the constant attention (and payments) that short-term creditors receive, and they do not have the upside potential that excites equity holders. Long-term creditors usually take what they hope is minimal risk in exchange for earning a fixed rate of return. As a company spirals deeper and deeper into financial trouble, however, the significance of the long-term creditor usually strengthens, and in extreme situations it is often the long-term creditors that end up owning or deciding the fate of the company.

Deferred Taxes

These are long-term liabilities that arise out of timing differences between GAAP accounting and tax accounting. When Congress has allowed certain tax benefits, such as faster depreciation write-offs for tax purposes than the deciders of GAAP allow, these differences create accelerated expense write-offs and lower (than GAAP) taxable income in early years. The tax deferral is from a GAAP standpoint only ' the company has paid the proper tax according to tax law. The theory is that eventually these timing differences between tax law and GAAP will reverse, and in later years this deferred tax liability will be paid back when GAAP catches up to reality. During the past few years, Congress has been trying to stimulate capital investment, and depreciation allowances have become increasingly accelerated and liberal, which has caused many companies to record larger and larger deferred tax liabilities. If the company continues to grow and replace assets, or if Congress continues to tinker with tax law, or if the company becomes insolvent, these “liabilities” may never actually be “paid back.”

Pension Plan and Retirement

Pension plan and retirement liabilities used to receive little attention, but have been very prominent in the news during the current economic cycle. These obligations were a major component of the General Motors and Chrysler bankruptcies, and so politically sensitive that the government strong-armed secured creditors to elevate these liabilities to a much higher priority than the bankruptcy code typically provides for them. The liability shown on the balance sheet represents the unfunded amount of what an actuary has determined is the company's obligation. Governments, which generally do not follow GAAP, swept these obligations under the rug for a long time and seem to have all suddenly realized that they exist, they are huge, and they need to be dealt with.

Companies often record liabilities in the anticipation of incurring costs. For example, if a company plans a plant closure, the sale of a division at a loss, or a mass layoff, it may record a liability for what it expects the costs of those future actions to be. Some companies recorded huge liabilities when “Obamacare” was passed in 2010, even though the costs of that legislation are not expected to become actual cash outflows until 2014 and beyond. Remember one of the cardinal rules: Debits have to equal credits, and the corollary is that for every debit there is an equal and offsetting credit. The recording of these liabilities has as its equal offset a charge to the income statement that correspondingly reduces reported net income.

Contingent Liabilities

Contingent liabilities may or may not develop into real liabilities, depending on which side has the better lawyer. In addition to lawsuits, contingent liabilities can also arise from warranty obligations, non-compliance with government regulations, accidents, or self-insurance programs. If the impairment of an asset or incurrence of a liability is “probable” and the amount can be “reasonably estimated,” then this will be reflected on the balance sheet and income statement as a known item. If the contingent liability is only “reasonably possible” or the amount cannot be “reasonably estimated,” then the contingency gets disclosed in the footnotes to the financial statements, but does not appear on the financial statements themselves. “Reasonableness” is in the eye of the beholder, or in this case, of the accountant.

Transfer of Non-Current Assets

In the weird and wacky world of accounting, a liability that will be satisfied in the very near future (within 12 months) with the transfer of non-current assets is not considered a current liability. For example, if you had 10 years left on your mortgage, typically the principle that would be paid in the next 12 months is “current,” and the rest of the principle is “long-term.” However, if you were in default and the entire mortgage was subject to acceleration, the entire mortgage would be shown as “current” whether the lender had actually accelerated it or not. On the other hand, if your plan is to satisfy the mortgage in full by giving the building back to the bank, since the building is a fixed asset, none of the mortgage is considered “current.”

Legally Enforceable Debt

The fact that a liability appears on the balance sheet does not mean that it is a legally enforceable debt, or that it will liquidated for the amount shown on the financial statements.' For example, a liability for repairs under warranty is not an actual debt to an actual customer ' it is an estimate based on historical patterns of what product returns may be. At the time warranty costs and liabilities are recorded, it is not known which customers, if any, may be bringing a product back to the company. If product quality has increased or decreased, or customers have gotten more or less finicky, the real obligation for warranty repairs may be significantly less than or greater than what is recorded on the balance sheet.

Similarly, changes in market conditions from what the actuary used in the pension plan assumptions (such as interest rates being 1% instead of 8%) can significantly change the pension liability shown on the balance sheet.

Conclusion

Liabilities are subject to courts, negotiation, commercial practices, and economic reality. The old saying that “nothing is certain except for death and taxes” is for the most part true, except that in today's political environment there is less and less certainty regarding what tax policy will be. Accountants do their best in all this to record and classify liabilities as they expect them to be paid. Some liabilities are more certain than others, but at the end of the day, the only way to truly know what the amount and terms of an obligation were is when the check that satisfies that obligation clears the bank.

Michael Goldman, MBA, CPA, CVA, CFE, CFF, is principal of Michael Goldman and Associates, LLC in Deerfield, IL. His qualifications include Insolvency, Financing, Planning, Turnaround Management and Business Valuation. He may be reached at [email protected].