Liabilities in Accounting
Liability refers to the sum of money that the firm owes to the outsiders or the amount that the firm has to pay to the shareholders, investors, creditors, workers and employees, and many other parties. The company can settle these liabilities over time through cash, goods, or services. Some examples of liabilities are accounts payable, mortgage, bonds, warranties, deferred revenues, accrued expenses, etc. All the liabilities are presented on the left side of the balance sheet. Sometimes, liability can also mean a legal or regulatory risk or obligation.
The company can divide the liabilities into two parts:
1. Internal Liabilities
The amounts that the company has to pay the internal person of the company such as proprietor or owners are termed as internal liabilities, for example, capital and accumulated profits.
2. External Liabilities
The amounts that the company has to pay to the outsiders are termed external liabilities, for example, creditors, bank overdrafts, loans, etc.
Characteristics of Liabilities
Liabilities have the following characteristics:
- Occurrence of a Past Event
Liabilities must be based on a previous transaction or event. Liability does not become a liability of an enterprise until something causes it to become one.
The following are examples of transactions and other events and circumstances that result in liabilities. Acquisition of commodities and services, governmental impositions, and acts by an enterprise requiring it to pay or otherwise sacrifice assets to settle its voluntary non-reciprocal transfers to owners and others.
- Required Future Scarifies of assets
The core of responsibility is a future obligation or demand to sacrifice assets. A liability is a requirement for an organization to transfer assets, perform services, or otherwise expend assets in order to meet an obligation it has taken on or has been imposed on it.
The majority of current obligations in financial statements qualify as liabilities since they require an organization to give up assets in the future. Accounts and bills payable, wages and salaries payable, long-term debt, interest payable, dividends payable, and other cash-flow-related obligations all appear to be liabilities.
- Obligation of Particular Organization
Liabilities are associated with specific businesses; therefore a needed future asset sacrifice is a responsibility of the business that must make the sacrifice. The majority of liabilities are based on contracts and other agreements that are enforceable by courts or governmental measures that have the force of law, and the fact that an enterprise has a duty is so obvious that it is typically taken for granted.
- Liabilities and Proceeds
When a business incurs liabilities, it frequently receives cash, products, or services, and the amount obtained is referred to as proceeds, especially when cash is received. Receipt of proceeds may show that a company has incurred one or more liabilities, but it is not conclusive proof.
The essence of a liability is a legal, equitable, or constructive commitment to forego future economic advantages, regardless of whether proceeds were received as a result of incurring it. Proceeds are not liabilities in and of themselves.
- Discontinuance of Liability
An enterprise's liability remains a liability until it is settled in another transaction or other event or circumstance that affects the enterprise. The majority of liabilities are paid in cash.
Others are satisfied by the company transferring assets or delivering services to other businesses, and some of them-for example, liabilities to provide publications under a prepaid subscription agreement-involve performance to generate money. Forgiveness, compromise, or altered circumstances might also result in the removal of liabilities.
- Capital and Dividend
In financial accounting, capital invested by the owner or shareholders in an enterprise is not considered an external liability. However, once a dividend has been announced, shareholders have a legal right to receive it. Unpaid or unclaimed dividends are thus recorded as current liabilities. Proposed dividends are typically shown as current liabilities as well, because they are normally final payouts for the year, which must be approved at the annual general meeting before the year's accounts are laid.
How to Calculate Liabilities?
There are various steps involved in the process of calculating liabilities. They include the following:
- List Your Liabilities
This is the first step in the process of calculating liabilities. At this step you are required to make a list of all liabilities that take place in the business whether they are short-term or long-term.
- Make a Balance Sheet
The next step in the process is the preparation of a balance sheet which represents the financial position of a business. The balance sheet is the prime financial statement that is used by the users of accounting information for various purposes. These users can be internal as well as external. The balance sheet has two columns: Liabilities and Shareholders' Equity (on the left-hand side) and Assets (on the right-hand side). The total of both these sides always tally with each other, i.e., remain equal. For making a simple balance sheet, you can use excel.
- Add up Your Liabilities
At this step, the value of all liabilities will be added to get the total amount that the firm owes to the outsider.
- Use the Basic Accounting Formula
In the last step, the accounting formula of double-entry bookkeeping will be used to calculate the total liabilities. The formula is:
Liabilities = Assets - Equity
Assets are the items that are owned by the company or that will provide profit to the company. On the other hand, equity refers to the value ofa company's share capital.
Types of Liabilities
Mainly, there are two types of liabilities: current or short-term and non-current or long-term. Both these liabilities are explained in detail below:
1. Current Liabilities
These are the short-term liabilities that are to be paid by the company within a shorter period of time, generally one year. Some of the current liabilities are as follows:
- Wages And Salary Payable
The total of accrued income that has been earned by the workers or employees but not yet received from the company is called the wages or salary payable. This liability can change often in the case of wages.
- Interest Payable
Just like the wages or salary, the amount for which the company has purchased the goods or services but has not yet made the payment. These goods and services are purchased on short-term credit by the company.
- Dividends Payable
This is the liability for the companies which have issued stocks to the holders and declare the dividend but have not yet paid.
- Unearned Revenues
The obligation of a corporation to deliver goods and/or services at a later period after being paid in advance. Once the goods or service is supplied, this sum will be lowered in the future with an offsetting entry.
- Outstanding Expense
These are the expenses that have occurred but have not been paid means the payment which is still due to the business.
- Liabilities of Discontinued operations
This is a one-of-a-kind risk that most people overlook but should be examined more attentively. Companies must account for the financial impact of operations, divisions, or entities that are now for sale or have previously been sold. This includes the financial impact of a product line that is currently being phased out or has previously been phased out.
2. Non-current Liabilities
These are the long-term liabilities that are to be paid by the company after a long period of time generally more than one year. Some of these liabilities are paid at the time of the wind-up of the company. Some of the non-current liabilities are as follows:
- Warranty Liability
Some liabilities must be estimated since they are not as precise as AP. It is the projected amount of time and money that will be spent fixing products once a warranty has been agreed upon. This is a typical automotive liability, as most cars come with lengthy warranties that can be pricey.
- Contingent Liability Evaluation
A contingent liability is an obligation that may arise as a result of the outcome of a future event that is unpredictable.
- Deferred Credits
Depending on the circumstances of the transactions, this is a broad category that can be classified as current or non-current. These credits are revenue that has been obtained prior to being earned and recorded on the income statement. Customer advances, deferred revenue, or a transaction in which credits are owed but not yet recognized revenue are all examples of this. This item is reduced by the amount earned and becomes part of the company's income stream once the money is no longer postponed.
- Post-employment Benefits
Benefits that an employee or his or her family members may get following retirement are carried as a long-term liability as they accrue. This accounts for one-half of the entire non-current debt at AT&T, second only to long-term debt. This liability should not be neglected, especially in light of rapidly rising healthcare costs and deferred compensation.
- Unamortized Investment Tax Credits (UITC)
This is the difference between an asset's historical cost and the amount depreciated already. The fraction that hasn't been amortized is a liability, but it's merely an approximate estimate of the asset's fair market value. This gives an analyst some insight into how aggressive or conservative a company's depreciation techniques are.
Advantages of Liabilities
Some of the advantages of liabilities in the business are as follows:
- To assess the viability of the company it is necessary to include the liabilities.
- The liabilities of a company represent its fiscal health which is an important factor for various interested parties such as economists, creditors, investors, etc.
- Liabilities are important to calculate the working capital of the firm. For this current liabilities are subtracted from the current assets of the business.
- The long-term solvency of the business can also be known by knowing its long-term liabilities. Solvency represents a firm's ability to pay off its debts as and when they get matured.
- In the case of small-scalebusinesses, the owner must not eliminate all liabilities.
Disadvantages of Liabilities
Some of the disadvantages of the liabilities in the business are as follows:
- The lender has the sole obligation of the repayment of liabilities even if the business is suffering loss or gets failed.
- The interest rates of some liabilities are very high. The cause of such high rates can be certain macroeconomic conditions in the market, the company's history with the banks and other credit agencies, thecredit rating of the company, and personal credit history.
- The company brings a practice on debt named "levering up" when it requires money. Such a loan of the firm is noted in the credit report and affects its credit ratings.
- The company must generate sufficient cash flow at the time of the repayment of the loan and sometimes, the business gets failed to arrange the required cash flow which causes late payment of loans and affects the goodwill of the company as well as increases the cost of repayment. In most cases, collateral is taken by the lender to avoid the bad debts which can also cause a loss to the company if it gets failed to repay the loan.
Liabilities vs Expenses
Many people got confused between the terms liabilities and expenses and used them interchangeably. But there is a difference between them which can be understood with the help of the given table.
|1) The sum of money that the firm owes to the outsiders is known as liabilities.
||1) The cost of operation that is invited to generate revenue for the customers is known as an expense.
|2) Liabilities are recorded in the balance sheet of the company.
||2) Expenses are recorded in the income statement of the company.
|3) If an expense is not paid on time then it becomes a liability and is called outstanding expenses.
||3) If the immediate payment of the expense is done on time via cash or bank then it does not become a liability.
|4) Example: bills payables, dividend payable, loans, interest payable, wages and salaries, unearned revenues, etc.
||4) Example: rent, insurance charges, bank fees and interest, stamp duty, broker charges, electricity, and other bills, etc.