CHAPTER XIX

LIABILITIES ON THE BALANCE SHEET; CURRENT AND CONTINGENT LIABILITIES

Form and Valuation

The problem of handling liabilities on the balance sheet is usually not so complicated as that of assets. The questions of arrangement, form, groups, and suitable nomenclature have in the case of liabilities an equal or even greater importance than that of the assets, the governing principle being clearness and fullness in the information given, with due regard to the purpose and intended use of the balance sheet.

The problem of valuation, which assumes great importance in the treatment of the assets, has normally little or no significance in the consideration of liabilities. This is due to several causes. In the first place, human nature being what it is, there is normally little danger of an overstatement of liabilities; they are usually sufficiently large, and no desire exists to make them appear more than they really are. Secondly, and likewise based on human frailty, while a concern may desire to undervalue its liabilities, the other party to the liability, the person holding the claim, can usually be depended upon to press his claim with sufficient insistence as to make the concern aware at all times of the amount of its liabilities.

From the viewpoint of a going concern, while all business experience points to a decrease and a necessary diminution in the values at which certain assets may appear on the books, no such diminution in the value of liabilities can be looked for; as legitimate claims must be met if a business is to exist as a going concern. Similarly, there is normally no tendency to inflate the liabilities by the inclusion of items which do not rank fully in this class—intangible liabilities seldom find place in any balance sheet.

On the other hand, there is frequently a very real hesitancy about the inclusion of some liability items until their claim becomes urgent or their full liability status becomes determined. Occasionally, and usually with ulterior intent, the liabilities may be inflated in value and items included therein which are fictitious; but our present concern is not with such conditions.

The one principle underlying the showing of both assets and liabilities is that their true status should be indicated. As applied to liabilities this means that they should be shown not only in correct amount but also in their true light, viz.: that all facts bearing on their relation to the business which ought to be known properly to judge conditions must be stated. The chief problem in handling liabilities is, therefore, how to show and list them so as to accomplish this purpose of truth and usually the further purpose of full truth. In a consideration of this problem, the auxiliary one of the inclusion of doubtful items among the liabilities will also receive consideration.

Arrangement on Balance Sheet

As to the classification and arrangement of liabilities on the balance sheet, it may be stated in a general way that whatever classification and arrangement are adopted for the assets, the liabilities should be shown similarly. For most purposes a standard grouping under the captions, Current, Deferred Income, Fixed or Funded, will suffice. The order of the groups as given here follows the order given for the assets. This is desirable for purposes of easy comparison, because in this way current liabilities are brought into juxtaposition with the group of assets to which current creditors must look for payment of their claims; and fixed liabilities and capital are opposed to the assets in which for the most part they have been invested.

Items within Groups

Arrangement within the group may be attempted on the basis of relative degree of liquidity of the items. This, however, is not always determinable nor is it an end to be sought; the chief desideratum is to show items in the main group to which they properly belong.

The manner of listing the items within the group is not a question of relative order so much as it is of nomenclature and clearness of expression. Thus, desirable and valuable information would be given by a separation of the items to show (1) those past due; (2) those due but not payable because of their credit term; (3) those neither due nor payable, such as accruing items; and (4) contingent liabilities. It may be remarked that such an analysis is seldom seen on the ordinary balance sheet. Corporations which have to report to a regulating body may be required to give more information concerning their business than those not so regulated. For internal use the suggested analysis has undoubted merit. For public use, it is neither necessary nor usually desirable that the information be given in that form; a showing of the items under the usual titles within the group to which they properly belong being here deemed sufficient.

P. J. Esquerré, in “Applied Theory of Accounts.”

Cancellation of Liabilities against Assets

Occasionally the practice is met of cancelling the liabilities, or some group of them, against corresponding assets, showing only the net assets remaining. Thus, Current Assets less Current Claims might appear as an item among the assets. Even for publication purposes this would not be deemed sufficient; for the outsider as a prospective creditor or investor has a right to judge for himself the relative sufficiency of the assets to meet the claims of creditors. No basis for such judgment is offered by a cancellation of the one against the other with a showing of the net amount only. A somewhat analogous situation arises in the double-account form of statement used by some English companies. Here, the capital assets are canceled against the capital and fixed liabilities and only the net surplus—usually of capital—appears in the balance sheet proper. The criticism is not so pertinent here, however, because almost invariably the balance sheet is accompanied by the so-called capital account which shows the full detail of the net item in the balance sheet. So also, the practice is often condoned wherever an accompanying schedule shows the full facts as to assets and liabilities. As a matter of principle, it should be condemned because accompanying schedules do not always “accompany.”

Inventory of Liabilities

The principle of showing the full truth as to the liabilities raises the problem of the complete inclusion or inventory of the liabilities. Under this will be considered any adjustments that must be made in the book record in order to show the true state of the liabilities, and also the proper treatment of contingent liabilities so as to show their relation to the state of the business.

The adjustment of the book record is not usually complicated. The necessary data are for the most part available. All that is required is an analysis of each item to determine what, if any, adjustment is needed to bring the books to a true statement of conditions as on the date of the balance sheet. These adjustments fall into six main groups, only two of which appear among the liabilities, while one of the others is often based on information obtainable only from an analysis of the liabilities. These groups are:

1. Accrued Expenses 2. Deferred Income 3. Deferred Expenses 4. Accrued Income 5. Valuation Reserves 6. Merchandise Inventory

The first three groups are discussed below, as well as another analogous group.

Accrued Expenses. These expenses comprise the liability existing at the close of a fiscal period because of expenses incurred but not settled for and oftentimes not yet due. Information as to these may be gathered—not in completeness however—from an examination of the various expense accounts and a somewhat intimate knowledge of the operations of the business. Unless a record is kept of all services being rendered to the business, it is very easy to omit some items of this kind. These will be discussed in detail under “Current Liabilities,” page 350.

Deferred Income. This income comprises the items of income received in advance of the full performance of the service required to earn it. In cases of this kind there are in the possession of the business certain assets which must be used to perform the service not yet completed in order to entitle the business to the full enjoyment of the income. That is, the property of the owners is liable for the service not yet rendered. Also, in order to make a correct showing of results as between the current fiscal period and the next, this unearned income must be carried forward for credit in the period in which the service is performed.

Premium on Bonds. Somewhat analogous to deferred income is the item of premium on bonds. As indicated in Chapter XV this is preferably treated as a direct deduction from the periodic interest payments on the bonds, because the bonds were marketed at a rate higher than the interest rate prevailing at the time of their flotation. Inasmuch as the premium must be spread over the life of the bonds, its unexpired portion will appear as of the nature of deferred income at all intermediate stages. A more detailed showing of this is given in