Let's talk now about the liability section of the balance sheet. Liabilities are obligations that the company must repay at some point in the future. There are three criteria that something needs to meet in order to be recorded as a liability in the books. A future payment must be probable, the amount of the obligation, it should be something that we can reasonably estimate. And the event that caused the obligation has already occurred or is currently occurred. If those three are met, we must record the liability in the books. Just as assets are classified as current or noncurrent liabilities are classified as current or noncurrent. That classification depends on when we expect to pay or satisfy the liability. If we expect that liability to be satisfied or paid within one year, then we would classify that liability as a current liability. But if we expect to pay or satisfy that obligation later than one year, then we would call that a noncurrent liability. Here's some common examples of liabilities. First one, accounts payable, that's the amount a company owes its suppliers for things that it's purchased in the past but hasn't yet paid for. The second, accrued expenses. These are expenses that have been incurred by the company that have not yet been paid. Third one is a deferred revenue. This is a liability that is incurred because a customer has paid cash to the organization but the organization has not yet provided the product or the service that the customer was paying for. In fact, once it satisfies that obligation and provides a product or service, it will be able to take the liability off the books and record it as revenue. The notes payable, or loans payable, these are amounts that we owe other parties. A loans payable, for example, would be the amount we would owe the bank for a loan that we had taken out. Bonds payable, that would be if we had issued bonds to investors in an effort to raise some funds, then that would be a liability that we would have to repay in the future. Let's look at some examples and see if we can determine whether or not they should be recorded as liabilities and if so, how much liability should be recorded. The first example, LL Wholesale buys products costing $3,000 from its suppliers in December, and it will pay the suppliers in February. Is a future payment probable? Yes, it's going to have to pay $3,000 in February. Can the amount of that obligation be estimated? Absolutely, it's $3,000. Has the event that caused the obligation to be incurred, has that already occurred? Yes, it has and that was the purchase of the products from the supplier in December. In that example, we will record accounts payable liability for $3,000. Example number 2, in November, a customer pays LL Wholesale $5,000 in cash for products that will be delivered in February. Is a future payment probable? Yes, in February, the company will have to deliver products to the customer. Is the amount of the obligation reasonably estimable? Yes, $5,000. Has the event that's caused the obligation already occurred? Yes, the customer paid $5,000 in cash to LL Wholesale. All three criteria are met, so we would record a $5,000 liability. We would call that deferred revenue, which is sometimes called customer deposit or customer advance or unearned revenue. But it's a liability that indicates the company's received cash and needs to provide products or services in the future. A third example, in December, LL Wholesale signs a contract with its supplier to purchase $7,000 of products the following March. Is a future payment probable? Assuming that it actually purchases the $7,000 of products in March, then yes, a future payment would be probable. Can the amount of the obligation be estimated? Yes, $7,000. Has the event that caused the obligation already occurred? No, it hasn't. The obligation to pay $7,000 to its supplier only arises when LL Wholesale purchases those products. At this point, the company would record no liability. The next example, in January, the same company obtains a 2-year loan from National Bank for $10,000. Interest rate 10%. Interest payable at the end of the 2-year period. In January, let's talk about whether a liability is recorded. A liability will be recorded for the $10,000 loan, in January when the loan is obtained. A future payment is probable because the company will have to pay back the $10,000. The amount is reasonable to estimate. It's $10,000. And the event causing the obligation has occurred. The company's borrowed the money and received the cash. In January, the company will record a liability for that $10,000 and they could call it a loan payable. But what about the interest that the company will owe on the loan? What should be recorded in the form of a liability in January? Actually, there is no liability recorded in January. Is a future payment of interest probable? Yes, assuming that the loan continues to remain outstanding and is not repaid. Can the amount be reasonably estimated? A 10% rate times a $10,000 loan gives us the amount of annual interest. Yes, it can be reasonably estimated. Has the event that causes the obligation to be incurred happened? No, time must pass in order for the company to owe interest on that loan. That event has not happened as of January. Think about it this way, if the company went to the bank on the same day and said I've changed my mind, I don't want the loan, it would return the $10,000 in cash and it would not owe a year's worth of interest. In summary, in January, the loan is recorded as a liability but no liability for interest is recorded until time has passed. Next example, example five. Employees of the company will be paid $2,000 in January for work completed in December. Does a company need to record a liability in December? Yes, it does. Is a future payment probable? Yes, the payment will be made in the paychecks in January. Can the amount of the obligation be estimated? Absolutely, it's $2,000. Has the event that caused the obligation already occurred? Yes, the employees have worked in December so they are owed the $2,000. We would record a wages payable or salaries payable, for $2,000 as a liability. Example six, this is a neat one. A customer files a lawsuit for $100,000 against LL Wholesale claiming that the products they received were defective. So customer files a lawsuit. Is a future payment probable? We don't know. Can the amount of the obligation be reasonably estimated? We really don't know, it depends on what the jury awards, I guess. Has the event that caused the obligation already incurred? Yes, it has, the products that were defective. We have an event that causes this obligation has already incurred, but the degree to which we're sure whether a future payment is probable or not is hard to determine, and the amount of the obligation is also hard to determine. Whether we record a liability or not depends on how probable we think the future payment is and how confident we are in the amount that we can estimate that we will likely have to pay.
