Liabilities are the things that you owe. Liabilities require the future sacrifice of assets. In business, however, credit is often used rather than paying with cash or a check. If we purchase something on credit, the credit will be to Accounts Payable rather than to Cash. Like assets, liabilities are classified as current liabilities or non current (also called long term liabilities). Current liabilities are those liabilities that are expected to be satisfied within the next twelve months (the next year). Non current liabilities are those liabilities that are not expected to be satisfied within the next twelve months. In some cases, a portion of a liability will be paid within the next year and another portion will not be. A good example of this is a mortgage.
Liabilities are defined as: “a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits”.
To understand this definition fully, each phrase must be analyze separately as below:
- Present obligation
- Past events
- Outflow of economic benefits
A legal obligation is evidence that a liability exists because there is another person or entity having a legal claim to payment. Most liabilities arise because a legal obligation exists, either by contract or by statute law. However, a legal obligation is not a necessary condition. There may be a commercial penalty faced by the business if it takes a certain action. For example, a decision to close a line of business will lead to the knowledge of likely redundancy costs long before the employees are actually made redundant and the legal obligation becomes due.
There may be an obligation imposed by custom and practice, such as a condition of the trade that a penalty operates for those who pay bills late. There may be a future obligation caused by actions and events of the current period where, for example, a profit taken by a company now may lead to a taxation liability at a later date which does not arise at this time because of the wording of the tax laws.
A decision to buy supplies or to acquire a new non-current asset is not sufficient to create a liability. It could be argued that the decision is an event creating an obligation, but it is such a difficult type of event to verify that accounting prefers not to rely too much on the point at which a decision is made. Most liabilities are related to a transaction. Normally the transaction involves receiving goods or services, receiving delivery of new non-current assets such as vehicles and equipment, or borrowing money from a lender.
In all these cases there is documentary evidence that the transaction has taken place. Where the existence of a liability is somewhat in doubt, subsequent events may help to confirm its existence at the date of the financial statements. For example, when a company offers to repair goods under a warranty arrangement, the liability exists from the moment the warranty is offered. It may, however, be unclear as to the extent of the liability until a pattern of customer complaints is established. Until that time there will have to be an estimate of the liability. In accounting this estimate is called a provision. Amounts referred to as provisions are included under the general heading of liabilities.
Outflow of economic benefits
The resource of cash is the economic benefit transferable in respect of most obligations. The transfer of property in settlement of an obligation would also constitute a transfer of economic benefits. More rarely, economic benefits could be transferred by offering a resource such as labor in settlement of an obligation.
The most familiar types of liabilities arise in those situations where specific amounts of money are owed by an entity to specific persons called creditors. There is usually no doubt about the amount of money owed and the date on which payment is due. Such persons may be trade creditors, the general name for those suppliers who have provided goods or services in return for a promise of payment later. Amounts due to trade creditors are described as trade payables.
>>> Read Types of Accounts.
Examples of Liabilities
Here is a list of items commonly found in the liabilities section of the balance sheets of companies:
- Bank loans and overdrafts
- Trade payables (amounts due to suppliers of goods and services on credit terms)
- Taxation payable
- Accruals (amounts owing, such as unpaid expenses)
- Provision for deferred taxation
- Long-term loans.
Types of Liabilities
Liabilities are a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. The first items in this list would be classified as current liabilities because they will become due for payment within one year of the date of the financial statements. The last item would be classified as non-current liabilities because they will remain due by the business for longer than one year.
Liabilities are typically divided into two categories: short-term or Current Liabilities and Long Term Liabilities.
A current liability is a liability which satisfies any of the following criteria:
(a) It is expected to be settled in the entity’s normal operating cycle;
(b) It is held primarily for the purpose of being traded;
(c) It is due to be settled within 12 months after the reporting period.
Current liabilities are listed in the order in which they are expected to be satisfied. The ones that will be paid first are listed first.
>>> Read Types of Accounts.
A non-current liability is any liability that does not meet the definition of a current liability. Non-current liabilities are also described as long term liabilities. Non-current liabilities are grouped by type (Loans payable, Bonds payable, Notes payable and so on). The footnotes will usually explain the components of the non-current liabilities (the basic terms, maturities, interest rates, and so on).
Recognition of Liabilities
As with an assets, when an item has passed the tests of definition of a liability it may still fail the test of recognition. In practice, because of the concern for prudence, it is much more difficult for a liability to escape the statement of financial position (balance sheet). The condition for recognition of a liability uses wording which mirrors that used for recognition of the asset. The only difference is that the economic benefits are now expected to flow from the enterprise. A liability is recognized in the statement of financial position (balance sheet) when:
- It is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and
- The amount at which the settlement will take place can be measured reliably.
For current liabilities there will be a payment soon after the date of the financial statements and a past record of making such payments on time. For non-current liabilities (long-term liabilities) there will be a written agreement stating the terms and dates of repayment required. The enterprise will produce internal forecasts of cash flows which will indicate whether the cash resources will be adequate to allow that future benefit to flow from the enterprise.
Examples of liabilities which are not recognized in the statement of financial position are:
- A commitment to purchase new machinery next year (but not a firm contract)
- A remote, but potential, liability for a defective product, where no court action has yet commenced
- A guarantee given to support the bank overdraft of another company, where there is very little likelihood of being called upon to meet the guarantee.
Because of the prudent nature of accounting, the liabilities which are not recognized in the statement of financial position (balance sheet) may well be reported in note form under the heading contingent liabilities. This is referred to as disclosure by way of a note to the accounts.
Looking more closely at the list of liabilities which are not recognized, we see that the commitment to purchase is not legally binding and therefore the outflow of resources may not occur. The claim based on a product defect appears to be uncertain as to occurrence and as to amount. If there has been a court case or a settlement out of court then there should be a provision for further claims of a similar nature. In the case of the guarantee the facts as presented make it appear that an outflow of resources is unlikely. However, such appearances have in the past been deceiving to all concerned and there is often interesting reading in the note to the financial statements which describes the contingent liabilities.
Mukharji, A., & Hanif, M. (2003). Financial Accounting (Vol. 1). New Delhi: Tata McGraw-Hill Publishing Co.
Narayanswami, R. (2008). Financial Accounting: A Managerial Perspective. (3rd, Ed.) New Delhi: Prentice Hall of India.
Ramchandran, N., & Kakani, R. K. (2007). Financial Accounting for Management. (2nd, Ed.) New Delhi: Tata McGraw Hill.