What Is Unfunded Liability in Accounting?

In accounting terms, an unfunded liability is a future financial obligation without sufficient assets designated for paying that obligation. Private companies and organizations can incur unfunded liabilities, but they've become a particular concern for governments, which have accumulated tens of trillions of dollars in commitments without matching revenue.

Accounting Principles

Under the generally accepted accounting principles that form the basis of most financial reporting in the United States, companies that take on financial obligations must report those obligations as liabilities at the time they're incurred. So if a company were to promise its 500 employees that it would pay each of them a $10,000 bonus two years in the future, it would have to immediately put that $5 million liability on its balance sheet. And because a balance sheet must, by definition, balance, the company has to make a provision for paying that $5 million.

Unfunded Liabilities

Unfunded liabilities arise when the cost of a financial obligation is understated, either intentionally or unintentionally, or the value of the asset intended to pay for the obligation is overstated. Say a company promises to cover certain health-care costs of retirees, and it estimates the cost of doing so at $100 million. It puts the liability on its books at $100 million, and it says it will pay for it using the proceeds of certain investments, projected to be $100 million. Everything balances out -- on paper. But if health care costs rise, which they're wont to do, or if investment projections don't bear out, which happens all the time, then there will not be enough money to cover the cost. A portion of the liability is unfunded. The company may just have to hope that future cash flows make up the difference.

Government

Unfunded liabilities can and do plague companies' pension and health care commitments, but where they really rear their head is in government accounting, particularly at the federal level. State and local governments are generally bound by the same accounting principles as companies. The federal government, however, is not. The federal government doesn't have to record liabilities until it actually pays out money, and Congress can pull programs off the government's balance sheet entirely. As a result, enormous future liabilities can be treated almost as if they don't exist.

Scope

There are no reliable estimates of the total amount of unfunded corporate liabilities in the United States. As just one illustration, "Financial Executive" magazine reported in 2008 that the 500 major corporations in the Standard & Poor's 500 index had a combined unfunded liability of $292 billion just for retirees' nonpension benefits -- primarily health care costs. Meanwhile, "USA Today" reporters spent years tracking the growth of unfunded government liabilities, primarily for Social Security and Medicare but also for government workers' retirement benefits and other programs. In 2011 the newspaper reported that those unfunded federal, state and local liabilities added up to $61.6 trillion -- the equivalent of more than half a million dollars per U.S. household.

References

• "Financial Management for Local Government," Volume 1; Kay Spearman et al; 2007
• "Financial Accounting for MBAs," Fourth Edition; Peter Easton et al; 2010
• "USA Today"; U.S. Funding for Future Promises Lags by Trillions; Dennis Cauchon; June 2011
• "Financial Executive"; Funding Options for Retiree Medical Benefits; Kevin L. Bachler and David S. Hauptman; August 2008