Generally, liability is anything that a company or an individual owes to another company or individual.
International Financial Reporting Standards (IFRS) Framework defines liability: “A liability is a present obligation arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits.“
Liabilities can be divided into two types: Financial liabilities and Non-Financial liabilities.
This article looks at the meaning and types of financial liabilities.
Definition and meaning
Financial liabilities are those liabilities in which a company or an individual has a contractual obligation to pay cash or deliver the financial asset.
For example, bank loans, finance lease liabilities, trade, and other payables, and other interest-bearing financial liabilities.
Financial liabilities are useful for all organizations. Owners undertake these liabilities to fund their businesses. They may invest in fixed assets and working capital to create a robust platform for their business.
Types of Financial Liabilities:
Financial liabilities are classified into two broad types based on the time period within which they become payable. Types of liabilities are:
- Current Liabilities; and
- Non-Current Liabilities.
1) Current Liabilities
Current liabilities are liabilities payable within 12 months from the time of receipt of economic benefit.
Say, if an entity has to pay creditors by purchasing raw material in 1-month time, that liability will be categorized under current liabilities. Similarly, the interest liability related to a long-term loan payable within the next year will come under current liabilities.
Examples of Current Liabilities:
Apart from interest payable and the current portion of a long-term loan, many liabilities can be classified under the term current liabilities.
These include salaries and wages payable and creditors payable, advance received from vendors, monthly utilities, and rent payable.
In certain circumstances, the timing or the value of the financial liability will be uncertain, and these are referred to as ‘provisions’ in the balance sheet. These are also classified as current.
The typical list of items found under this heading are:
- Accounts Payable is the sum of all unpaid vendors & service providers.
- Accrued Payroll – Usually, employees are paid in arrears. Thus, liability against salaries due is recorded as accrued payroll.
- Other Accrued Liabilities – As on the balance sheet, various expenses have been incurred by the organization, but their invoice has not yet been received, for example, utility bills and rent payable.
- Current Portion of Long-term Loan – in case of a loan payable in more than one year, this heading would only include the portion of the loan and interest that is payable in the current 12 months.
2) Non-Current Liabilities
Non-current liabilities are the liabilities that are payable after 12 months.
For example, if a debt is payable over 5 years, the amount payable after one year shall be classified under long-term liabilities.
As explained earlier, the amount owed within the next 12 months shall be classified under current liabilities.
Similarly, all other liabilities not required to be paid within the next 12 months shall be categorized as long-term liabilities.
Examples of Non-Current Liabilities:
Non-current liabilities include bonds or notes payable, finance leases, pension liabilities, post-retirement liabilities, and deferred compensation.
The typical list of items found listed under this heading are:
- Notes payable – The Notes Payable is a financial liability in which a borrower’s written promise to pay cash to a lender is recorded. (The lender records such promises as Notes Receivable). Generally, the written note specifies the principal amount, the interest to be paid, and the date due.
For most entities, if the note will be due within 12 months, the borrower will classify such note as payable under current liability.
If the note is due after 12 months, the note payable will be recorded under non-current liability.
- Pension obligations – The term pension obligation refers to the expenses or liabilities incurred and payable in the future, associated with the entity’s pension plan. Generally, pension obligations can be recorded in terms of accumulated, vested, and projected benefits.
- Finance leases –A finance lease is a method of providing finance to an entity where effectively a leasing company (the lessor or owner) buys the asset for the user (the lessee or hirer) and transfers substantially all of the risks and rewards of ownership of the asset to the lessee against monthly or quarterly payments for a fixed period.
- Long-term bond payables –The bond is a type of long-term debt usually issued by corporations, hospitals, and governments. The issuer makes a formal promise or an agreement to pay interest on bonds, usually semiannually, to pay the principal amount at an agreed date in the future.
- Long-term warranties – Some organizations give warranties as after-sales services to its customer to create a long and reliable relationship with them. These warranties, thus, are payable in more than one year and are classified as long-term.
- Long-term loans – Usually, businesses, to provide for their working capital, take long-term loans. The repayment of these loans is extended over greater than one year.
Financial liabilities can also be divided into two categories based on their relation to market prices or rates. These are:
- linked to market prices; and
- not linked to market prices;
Financial liabilities linked to market prices
These liabilities change with fluctuations in the market value or market rate in a specified market.
Examples of financial liabilities linked to market prices are contractual obligations like debt instruments not having a fixed rate, and loans issued on market-rate like KIBOR, the amount of which changes in proportion to the quoted market rate.
Financial Liabilities not linked to market prices These liabilities have fixed rates, so there is no effect of change in market rates. Examples include trade payables and accrued liabilities.