Why do people always make liabilities sound so complicated?
For example, *ahem* the semiannual interest payment for a five-year, $1,000 par-value bond with an annual 8% coupon is $40: ($1,000 x 0.08) / 2 = $80 / 2 = $40… or… if the bond was issued at a premium of $200, the semiannual amortization using the straight-line method is simply $20: ($200 / 5) / 2 = $40 / 2 = $20. Therefore, debit interest expense by $20 ($40 – $20), credit cash by $40 and debit premium on bonds payable by $20.
See? Nothin’ to it.
Easy for you to say.
Liabilities are complicated because people are forward-thinking. Humans do not live on cash flow alone. There must be accrual. And accruals are the stuff of science fiction because they suggest the future.
Liabilities Are Entanglements
In a practical sense, you don’t even need liabilities if every transaction is handled in the present tense. If Carpenter Brown gives Farmer Kozlowski a chair in exchange for a crate of eggs, that’s an inpromptu transaction, one and done. But if Kozlowski promises a year’s supply of eggs, then he owes Brown an egg a day. Liabilities, often called payables, are commitments to pay over time. Payables are entanglements, but they also reflect an optimism that you will be thriving long enough to make the payments.
Payables are the debts that you acquire in running a business. If they’re short-term, 90 days or less for example, they’re Accounts or Trade Payables. If you sign a longer term commitment, that’s a Loan Payable. Even Salaries might be put on the books since people typically work for a few days or weeks before they get paid.
Deferrals Are a Joke Only Accountants Get
Liabilities get weird very quickly. The underlying idea is that the balance sheet should reflect whatever you owe somebody. That includes the IRS. As I mentioned with “G is for GAAP,” the financial accounting rules have been developed by an independent body of accountants, who try to determine the most logical and prudent way for businesses to measure themselves consistently.
Tax policy, however, is created by Congress. Just throw “principles” out the window. IRS rules interpreting the bizarre and arcane agreements that Congress makes (with constituents, lobbyists, partisans, etc.) aren’t necessarily logical. When there’s a gulf between IRS and GAAP rules, it can mean that paying taxes can be put off or deferred. When taxes delayed become large enough, even those Deferred Taxes need to be listed as a liability. A common example occurs because GAAP allows more flexibility in how assets are depreciated (it’s called MACRS) than the IRS (which uses straight-line).
Deferred Tax Liabilities must be the ultimate in-joke for accountants. Accountants create these strange numerical ideas called liabilities and assets based on one set of rules, then interpret “tax policy,” based another set of rules, and create a third set of rules to reconcile them. As long as there is arithmetic, taxes, and ways to avoid them, there will always be accountants. Remember–they invented writing!
Leases and Other Mystical Creatures
Along with Deferrals, you get other interesting devices, like Leases. A lease is a gryphon of a financial entity, a hybrid creature. It’s both an asset and a liability. Most people think of a lease as for an apartment or a car, an agreement to use something for an extended period of time. That’s like a debt–a promise to pay rent for a year–but also an asset, since it’s a place to live or thing to drive for the foreseeable future.
Small businesses often lease equipment rather than buying it. The equipment goes on the books as an asset, even if it’s leased. The lease payable goes on the liability side because it’s an agreement to pay. But the actual calculation of the value of the pizza oven or computer network is done by a mathemagician. The equipment on the books is the present value of all the future lease payments valued at a discount rate.
To an accountant, that’s just punching buttons on the old trust HP 12-C, but to the average person, that might as well be a lion with an eagle’s head on it.
Look, here’s a company that leases airplanes that already gets it.
I mean, imagine the “overhead.”
#SorryNotSorry
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After one of my sons (the one who is now planning to become an accountant) bought a condo unit (pretty much immediately after graduating with his bachelor degree), we were playing cards, one night (about five years ago) at a party when I mentioned depreciation on his property (which I’d helped him pick after helping him him select* an agent). He balked, and I said that it doesn’t decrease the value. He acted like I was nuts or wildly misinformed; I responded, “Alright,” with a shrug, and went on playing. He got right onto google and found out I was telling him something important. That was both sort of a funny moment and a zen moment. One of my favorite memories.
You said: Small businesses often lease equipment rather than buying it. The equipment goes on the books as an asset, even if it’s leased. The lease payable goes on the liability side because it’s an agreement to pay. But the actual calculation of the value of the pizza oven or computer network is done by a mathemagician.
I would think so!
And you said: The equipment on the books is the present value of all the future lease payments valued at a discount rate.
I imagine this is different from depreciation.
To an accountant, that’s just punching buttons on the old trust HP 12-C, but to the average person, that might as well be a lion with an eagle’s head on it.
Anyway, I enjoyed being clued in on the following: When there’s a gulf between IRS and GAAP rules, it can mean that paying taxes can be put off or deferred. When taxes delayed become large enough, even those Deferred Taxes need to be listed as a liability. A common example occurs because GAAP allows more flexibility in how assets are depreciated (it’s called MACRS) than the IRS (which uses straight-line).
Deferred Tax Liabilities must be the ultimate in-joke for accountants. …..
* The first one a particular office assigned to him was condescending to my son before getting busy with anything else. Sat him down to a rambling, sort of meaningless, lecture for a half hour. I suppose it was because my son was only twenty-one. Then, we were taken to see a place. I could see it wasn’t worth the price, but the man said it was good for the money with some fixing up.The main disadvantage of being that young was that he wouldn’t have known this man was being condescending and inappropriate. So I told him, and that was the end of that (along with the end of the guy).
Your most complicated paragraph was the one with the word “bond” in it. I’ve realized, before, that I should know more where that is concerned. I’m not even gonna ask.
I love your stories; thanks for sharing!
Bonds are complicated things that accountants have to study without really understanding what they are because you really learn how to handle something that only large corporations issue. Most of think about buying government bonds or bonds on the market, not accounting for issuing them. I never came within a breath of having to account for a bond, whereas I did have to balance incoming receipts, calculate inventory, close the books, do budgeting, etc. I think Bonds were complicated things invented just to practice long division.
I don’t blame your son for trying to understand the difference between an asset value on “the books” vs. in real life. Real estate is a thing that increases in value even while it gets older. Makes me wonder whether wine is depreciated; probably not?
But your question makes me think maybe I can fit a post in there about the eternal tension underlying modern financial statements… minimizing expenses on the financials shown to investors (we make lotta money, give us yours!) vs. maximizing expenses to the IRS (we’re so poor, we can’t pay taxes). I will have to noodle about that and see if there’s an alphabet piece I can use for it.
😁
😀 back at ya