Definition
Liabilities in accounting are defined as a sacrifice of future economic benefits a company is under obligation to perform as a result of the past transactions with a different entity.
Example
Consider a bakery that wants to buy a dough machine. The price of the dough machine is five thousand dollars. The owner of the Bakery goes to a bank and borrows five thousand dollars. The owner then purchases the dough machinery for the bakery.
Now, the owner has a dough machine worth five thousand dollars, but the owner also has a liability, the bank loan, worth five thousand dollars, which would be a bit more because the bank would charge interest on the five thousand dollars.
In double-entry bookkeeping accounting, the journal entry of the bakery would show that the worth of its assets increased by five thousand dollars, but the value of its liabilities has also gone up five thousand dollars. In the end, the net value of the assets and liabilities remained the same.
Measurement of Liabilities
Liabilities are divided into two main types: current and non-current liabilities. Current liabilities are which are expected to be settled within a year, and non-current liabilities are those which may take more than a year to settle.
The current liabilities are measured by taking into account and adding up: account payable, note payable, accrued expenses, and deferred income. The non-current liabilities are measured by adding the long-term finances, and deferred tax liabilities. Adding up current and non-current liabilities gives us the total liabilities of a company.
Recognition
According to the International accounting standard board or IASB, ‘A liability is recognized in the books when it becomes probable that an outflow of resources providing 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.
It is clear from the IASB definition that liabilities that are recognized must be current ones, and these arise from past events. It also means that a future obligation is not recognized as a liability, for example, a bank loan that a company expects to take in a year.
Types of liabilities in accounting
The types of liabilities that are used in accounting are shown in figure 1 below:
Figure 1: Main types of liabilities
There are three main types of liabilities shown in figure 1. These are current liabilities, non-current liabilities, and contingent liabilities. All of these three types are explained in great detail below:
Current Liabilities
Current liabilities are those liabilities or obligations which are due within a year. These liabilities are extremely tricky to manage because as these are due within a year, the management of the company needs to ensure that it possesses ample liquidity to pay current liabilities.
Some of the examples of the current liabilities are as follows:
Short-term debt: This is the debt that is due within a year. During uncertain economic times or economic conditions, companies may borrow for the short term to tide over any uncertain economic condition. The short-term debt is classified as a current liability.
Interest payable: When a company borrows, it has to pay that money backs. The interest payable notes the interest payments in the books. The interest payments can be made monthly, quarterly or annually depending upon the term of the loan.
Taxes: Taxes are also classified as current liabilities because every year, a company has to pay its taxes.
Bills Payable: All the bills that a company has to pay are noted as current liabilities. Utility bills, rent payments, and payments to suppliers are all classified as bills payables.
Fines: When payments are made not on time, there are some fines that a company has to pay. These can be overdraft or late payment fines to the suppliers.
Non-Current liabilities
These are the liabilities that are not due within a year. The non-current liabilities are also known as long-term liabilities. The non-current liabilities provide a picture of the long-term health of a company. Does the company meet its long-term liabilities? It also tells us whether a company can survive in the future or would it go bankrupt.
The companies borrow money on a long-term basis to finance new projects such as factories, which require a significant amount of investment. By borrowing on a long-term basis, companies are better able to manage their finances. Different types of bills or payments which are associated with non-current liabilities are noted below:
Bonds Payable: Sometimes, a company instead of borrowing money from the bank would finance its project by issuing bonds. The timeline of these bonds can be anywhere between three to ten years. Companies have started issuing even longer-term bonds which may last up to 30 years.
Capital leases: Companies may lease capital equipment. The average timeline for the capital lease agreements lasts about when 75 % of the capital is depreciated. This can take years, and as a result, capital leases are classified as non-current liabilities.
Long-term Loans: The long-term loans which a company takes out to finance its projects from the bank. This borrowing method is used by small companies which are unable to issue bonds.
Contingent liabilities
This is the third type of liability. Contingent liabilities are those liabilities that may only be classified as liabilities if only certain events happen in the future. The contingent liabilities may become current liabilities or non-current liabilities depending upon the results of the future events. Some examples of contingent liabilities are as follows:
Lawsuits: When the company gets sued, the prospective payout to the people who filed the lawsuit becomes a contingent liability for the company. In this case, whether this liability becomes a real issue depends upon whether the company loses the lawsuit or not. If the company loses the lawsuit, the contingent liability changes into a current liability. This is due to the fact that it would have to be paid within a year unless the involved parties agree on some sort of different payment.
Product warranties: Product warranties like lawsuits only become real liabilities, if the product which is warranted broke down or gets damaged. The liability in this case would be what the company has to pay to replace that product.
Frequently asked question
What are the classifications of financial liabilities?
Financial liabilities are classified based on amortization of that particular liability by taking into account the fair value of the liability on profit or loss terms. A financial liability may also be classified based on the nature of that financial product.
For example, whether it is a financial derivate or hedge or swap, or other financial products. The financial liabilities are classified at a fair value.
What is the principle for the recognition of a financial asset or a financial liability?
When recognizing a financial asset or a financial liability, there are two procedures that must be followed to recognize these financials in the accounting books. First of all, it must be recognized at a fair cost, and then in the second part, it must be recognized at not the fair cost.
The fair cost is the true cost of the financial cost or liability. The not fair value adjusts it’s for the cost of acquisition, costs such as accounting or administrative cost.
How do you calculate financial liabilities?
There are two types of financial liabilities: current and non-current liabilities. To calculate current liabilities, add up the short-term liabilities such as accounts payable, taxes, salaries, leases, and rent payments.
To calculate, non-current liabilities, add up deferred tax payments, and long-term loans. Finally, the third type of financial liabilities is contingent liabilities, which may or may not be added into the total financial liabilities, depending upon the future results of a very specific economic event that may be positive or negative for the company.
