Introduction to Liabilities: Definition, Types and Working

“Accounting does not make corporate earnings or balance sheets more volatile. Accounting just increases the transparency of volatility in earnings.”

-Diane Garnick

 

There is no second doubt that accounting is the vital element of the economy. As mentioned above, statement accounting increases the transparency of the financial events of the organizations and the individuals. But understanding the terms so accounting is a big task especially for the non-economics students.

 

Accounting includes different terms such as balance sheet, assets, liabilities, debts, debits and credits. A balance sheet is defined as the financial statement of an individual or organization. It includes assets, liabilities, equity capital, total debt, and other important measures of the accounting.

 

Debit is defined as the money withdrawn from an account, maybe current or savings. While credit is the amount of money deposited to the account. Debt is the borrowing money on the organization or individual that it is supposed to pay back. While it may follow or may not follow a particular interest rate.

  

Balance sheet comprises liabilities on one hand and assets on the other side. People are always confused in these two easy terms. In this blog we will study about liabilities in particular. The meaning of liabilities, its types and examples.

 

Also Read | Debt Funds

 

 

What is Liability?

 

Accounting of every business or organization mainly consists of two terms: assets and liability. Later all other aspects and terms of accounting depend and derived from these two. Liability in particular is more important.

 

A liability in financial aspects is defined as an obligation of the company that affects the company’s future sacrifices of economic benefits to other entities or business. Sometimes, it is defined as an alternative to equity as a source of a company’s financing. 

 

In simple language it is defined as something a person or company owes. It is usually considered in terms of money. Liabilities are stabilized over a time. It is settled through the transfer of economic benefits including money, goods or services. 

 

Unlike assets, liabilities are recorded on the right side of the balance sheets. And, it includes monetary loans, accounts payable, mortgages, bonds, warranties, deferred revenues, and some other expenses. 

 

Liability sometimes can also refer to a legal or regulatory risk. In accounting terms, liabilities are treated opposite to the assets. In one accounting year, the current liabilities of the company or organization is counted as the short-term financial obligations that are due that year.

 

Liabilities are the future sacrifices of the organization done to avail the economic benefits. This entity is obliged to make to another entity a result of past transactions or past events. The built settlement may result in the transfer of assets sometimes.

 

 

Characteristics of Liabilities

 

The general accounting equations is defined as 

 

Assets = Liabilities + Owner’s Equity

 

It relates the assets, liabilities and owner’s equity of an accounting statement.

 

The common characteristics of liabilities are as follows:

 

1. Liability is any time of borrowing done by the organizations or individuals. It is done to improve the personal income or business quota. It can be payable for short as well as payable for long terms.

 

2. Liability is defined as the duty or responsibility to other entities. It is settled by the future transfer or use of assets, or any other transactions that have potential to yield economic benefits. It is fixed for a specific date or time or event.

 

3. Liability is a duty or responsibility that obligates one entity to another leaving a little or almost no discretion.

 

4. Liability is characterized as a transaction obligating the entity or event that has already occurred.

 

5. Liabilities need not be legally enforceable every time.

 

6. Liabilities can be based on both equitable obligations and constructive obligations.

 

7. A liability is defined as the present obligations of the organization that has been raised from the past events and transactions.

 

8. The mentioned past settlement is expected to result in the outflow from the enterprise. 

 

9. Common examples of liabilities are IOU, mortgage owed money and money borrowed from the loans.

 

Clearing both the terms, equitable obligations and constructive obligations. An equitable obligation is based on moral and ethical consideration. A constructive obligation is an obligation that is based on a set of practical and beneficial considerations.

 

 

How do Liabilities Work?

 

As said in the above definitions, liability is basically an obligation between two parties. More or less defined by the previous business transactions or events. Depending upon their temporality, liabilities are classified under two types, current liabilities and non-current liabilities. 

 

Liabilities that are considered for short term are called current liabilities, while those which are considered for long durations are known as non-current liabilities.

 

Liabilities can include a future service owned to others or an unsettled obligation. The common liabilities include accounts payable and bonds payable. Most of the organizations and individuals mention these two terms, payable accounts and payable bonds on their balance sheet.

 

Liabilities pay for the large expansion and are also used to define finance operations. In many cases liabilities are useful for improving businesses, for example, a wine shop. The owner doesn’t demand payment when it delivers the goods to other organizations, in fact, it will invoice the organization. Thus, making payments and transactions easier.

 

The wine shop will consider this transaction as the liability and the other organization will consider the same transaction as the assets. As mentioned above, liabilities deliver so many functions for a company or an organization. 

 

Therefore, it is a vital aspect for the company. Liabilities refer to the money owed to another party. It can also be a property tax that is owed by house owners to the municipal government. 

 

Also Read | What is Opportunity Cost?

 

 

Different Types of Liabilities

 

Depending upon the temporality of liabilities, businesses and organizations classify liabilities into two major categories.

 

1. Current liabilities

 

2. Non-current liabilities

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Types of liabilities

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Current liabilities are the debts that are considered for the short terms and all payable within a year. While, non-current liabilities are long-term liabilities that take a longer period. There is also a third kind of Liability that is often ignored, called the Contingent Liability.  

 

Let us consider an example, a business takes a mortgage for over a period of 15 years, it is considered as a long-term liability, but the mortgage payments due for the current year are counted as the short-term liabilities section of the balance sheet. 

 

Current Liabilities

 

Current liabilities or short-term liabilities are the amount that can be liquidated within a year. The liquidation of current liabilities required current assets. It helps the analysts to see how much a company can pay the current liabilities that are due within a year.

 

Some major examples of current liabilities are wages, account taxes, monthly utilities, accounts payable and unearned revenue. The common examples of current assets are explained as:

 

1. Wages Payable: It is the total amount of accrued incomes that employees have earned but have not received yet. There were the times when companies used to pay monthly, but nowadays almost all companies pay their employees every two weeks. Thus, this liability changes often.

 

2. Interest Payable: Interest Payable arises when the company uses credit to purchase goods and services to finance over short time periods. Thus, this amount symbolizes short-term credit purchases.

 

3. Dividends Payable: Dividends Payable are the amount that companies use to issue stock to investors and pay a dividend. This dividend pops up four times a year.

 

4. Unearned Revenues: Unearned revenues are the company’s liability that deliver goods at a future date. For this the payment has been done already and the amount is deducted in the future with an offsetting entity.

 

5. Discontinued Operation: Liabilities of discontinued operation is unique in nature and should be scrutinized more closely.it impacts the financially down to the product line. The organizations for these liabilities are required to record the financial impact of different processes like operation or divisions.

 

Non-Current Liabilities

 

Non-current liabilities are also known as long term liabilities. These liabilities are not expected to liquidate within a year. The common non-current liabilities include long-term bonds, payable notes, pension obligations, long-term leases and product warranties. In simple words, any liabilities that can be liquidated within 12 months are not counted as non-current or long-term liabilities.

 

The top name in the list of non-current liabilities is bonds payable, also known as long term debt. Analysts from long term liabilities observe the ability of the organization to pay assets from the future earnings. The other examples are deferred taxes, payroll, and pension obligations.

 

1. Warranty Liability: Warranty on a product that is extended for more than 12 months is counted as warranty liability. It is calculated as the estimated amount of money and time that may be spent repairing products upon the warranty agreement.

 

2. Contingent Liability: This liability is defined to occur depending on the outcome of a future transaction or event that is yet to happen.

 

3. Deferred Credits: Deferred credit consists of a variety of liabilities. It may be recorded as current or non-current depending upon the characteristics of the transactions. It includes customer advances or the transaction where credits are owned but yet revenue is not considered.

 

4. Post-Employment Benefits: Post employment benefits are the benefits that are given to an employee or his family members after the former one gets retired. The rapid rise in health care and deferred compensation, doesn’t allow this liability to be overlooked.

 

5. Unamortized Investment Tax Credits: UITC is defined as the net between an asset’s historical value and the depreciated amount. It is an unamortized value and is roughly estimated as an asset’s fair market value. It is calculated by applying a conservative depreciation method.

 

Also Read | Amortization vs Depreciation

 

 

Contingent Liability

 

This is the third and ignored type of liability. Liabilities which are uncertain of the time are called as contingent liabilities or provisions. It is a special category of liabilities that may or may not arise depending upon the probability of an uncertain future event.

 

The contingent liability occurs only when these two conditions are fulfilled:

 

1. The outcome is probable.

 

2. The liability amount is reasonably estimated.

 

Even when one of these two conditions is not fulfilled, the organization doesn’t report any contingent liability on the balance sheet. The example of contingent liability is the legal liability. 

 

The expenses or the amount that is involved in the litigation of the company. In simple words, the legal expenses that can be borne by a company, if a case is filed against it are counted as contingent liabilities, and obviously they are uncertain 8as per as time and can occur at any time.

 

The accurate balance sheet is essential for an organization to note the net profits, loss and debt of the company. Liabilities are an essential part as they have a future financial impact on the business. That is everything you need to know about liabilities.