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Liability Definition and Types
What are liabilities?
Liabilities mean the debt amount owed by a company to pay past transactions. A company may owe this payment to creditors, lenders, banks, or other financial institutions. These payments are recorded as credits in the balance sheet of a company. Usually, short-term liabilities are placed before long-term ones.
According to the balance sheet, liabilities are total assets minus shareholders’ equity.
Liabilities = Total Assets – Total Shareholders Equity
Significance of liabilities section of the balance sheet
The liabilities component of the balance sheet helps businesses increase their value creation and organize business operations processes. They also help create capital structure and give a snapshot of the liquidity of the company. Long-term debts are important indicators of the long-term solvency of a company. Liabilities help determine long-term debts and hence help the company maintain the long-term solvency of a firm.
Types of Liabilities
There are usually three types of liabilities that can be found in the balance sheet. These are:
Non-current or long-term liabilities, and
Current liabilities are short-term debts that must be paid within the current cycle or one year. These debts are incurred due to the general operations of the company and the company incurring such debts must be prepared to pay them irrespective of what the amount of the current liabilities are if they intend to be recognized as a financially healthful company. The current liabilities can be divided into the following types:
Interest payable: This represents the interest expense accrued to date but is not paid to date according to the balance sheet. Interest payable is also termed accrued interest. Here is an example. Let’s say the incurred interest is 20,000 rupees which should be paid in the next fiscal year. In this case, the journal entry is recorded as ‘Interest payable: 1000’.
Accounts Payable: Accounts payable is another short-term liability that must be paid within one business cycle or most commonly one year. AP is generated whenever a company buys goods and services from its suppliers. These items, however, get reduced when the company pays off the obligations. Accounts payable is a very useful metric in the balance sheet of a company. Experts usually check the company’s liquidity using AP. Moreover, AP is also used to plan the cash cycle.
Accrued expenses: These expenses are the ones that are recognized at the time when they are incurred. This occurs irrespective of whether the cash has been paid or not. The two common types of AP are Accrued Salaries and Wages, and Accrued Interest. Interest payments on loans, warranties on products and services received, etc. are examples of accrued expenses. When debts are paid off, the account payable account is debited and the cash account is credited.
Income tax payables: As income tax must be paid within one year, it is considered to be a current liability. Other taxes that must be paid in the long term fall under the category of long-term liabilities.
Bank account overdrafts: When a payment is processed with insufficient funds available in the bank account, it is called an overdraft. The company must pay interest to the bank for an overdraft facility which is considered a current liability.
Non-current or long-term liabilities refer to financial obligations that the company must pay in more than one year. These long-term debts are usually used for financing the company’s operations Companies utilize these debts for gaining capital for investment purposes and purchase of assets.
The following are the different types of non-current debts:
Bonds payable: A company may issue bonds to generate cash to fund its operations. Issuing the bond creates long-term liability. Bonds can be issued at discount, at par, and at a premium. The price of a bond is dependent on the difference between the market yield on the issuance and the coupon rate of the bond.
Deferred Tax Liability: It comes up when the amount that the company deducts as tax and the taxes for accounting purposes are different from one another. These are the taxes that have been incurred but have not been paid yet. This item reserves money for a specific expense in the future on the balance sheet. It reduces the company’s cash flow available for other expenditures but the company can use it for paying taxes.
Mortgage payable: It is a promissory note secured by an asset where the title of the asset is pledged to the lender. It is payable in equal monthly or yearly installments that consist of both principal and interest throughout the loan term. It is usually done for buying a property.
Capital lease: It is a contract by which a lender uses assets on a temporary basis. This contract usually contains economic characteristics of asset ownership and is used for the purpose of accounting. It is also recorded on the balance sheet of a company. The renter books the assets and liabilities with a lease when the rental contract meets some given requirements.
These are the liabilities that may take place depending on the outcome of a future event. These liabilities are not sure to occur, meaning that they may or may not happen. As there is a chance of not occurring in the future, these debts are considered in accounting records only if the probability of occurrence of the debt is more than 50%. Government probes, outstanding lawsuits, liquidated damages, and product warranties are good examples of contingent liabilities.
A contingent liability has the power to impact the future net profitability and cash flow of a company negatively. Therefore, the knowledge and idea of the liability can help investors and creditors in meeting the requirements more wisely in the future. These liabilities have the potential to reduce profit generation for the company.
Liability is used to describe any kind of financial obligation to a person or a business that a business has to pay at the end of an accounting period.
Liabilities are settled by transferring money, goods, services, or other economic benefits.
Liabilities are usually recorded on the right-hand side of the balance sheet, which shows different types of loans, creditors, lenders, and suppliers.
Liabilities can be short-term and long-term. Short-term liabilities are due within an accounting period (12 months) and long-term liabilities are due within a duration of more than 12 months.
Liabilities are important to notice because they help gain an idea about the net revenue of a company. By subtracting, liabilities from the total shareholders’ equity one can gain an insight into the current liability which shows the net gain. This can help companies decide on their capital structure and the debt component. That is why liability is considered indispensable to gaining a proper view of the company’s financial health.
Q1. What are the three types of liabilities that can be found on a balance sheet?
Ans. There are usually three types of liabilities that can be found in the balance sheet. These are:
Non-current or long-term liabilities, and
Q2. What are current liabilities? Briefly illustrate.
Ans. Current liabilities are short-term debts that must be paid within the current cycle or one year. These debts are incurred due to the general operations of the company and the company incurring such debts must be prepared to pay them irrespective of what the amount of the current liabilities are if they intend to be recognized as a financially healthful company.
Q3. What is meant by short-term debt?
Ans. A debt is short-term then it is meant to be paid within 12 months or less.
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