Financial Accounting: In an Economic Context

SUMMARY OF KEY POINTS

Definition of a liability.

The FASB has defined liabilities as “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.” All liabilities appearing on the balance sheet should have three characteristics in common: (1) They should be present obligations that entail settlements by probable future transfers or uses of cash, goods, or services; (2) they should be unavoidable obligations; and (3) the transaction or event obligating the enterprise must have already happened.

Economic consequences associated with reporting liabilities on the financial statements.

Disclosing a liability on the balance sheet affects important financial ratios (e.g., current ratio, debt/equity, debt/assets) that are used by shareholders, investors, creditors, and others (1) to assess the financial performance and condition of a company and (2) to direct and control the actions of managers through contracts. Each of these parties has an economic interest in the amount of debt that a company must pay. Financial ratios, which use balance sheet liabilities, are also found in debt contracts to protect creditors by limiting future ...