In accounting, liability is the difference between assets and shareholder’s equity. It is necessarily not a bad thing since it helps in financing projects and facilitate investments.
In this article on what is liability, we will discuss the significance and types of liabilities.
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What is Liabilities?
Liabilities refer to the debt amount owed by a company to settle past transactions. The company may own this money to its suppliers, lender, bank, and other financial institutions. These are recorded as credits in the balance sheet in the order of payment terms. Short-term liabilities are placed before the long term.
Liabilities = Total Assets – Total Shareholders Equity
Significance of Liabilities
This component of the balance sheet helps businesses accelerate value creation and organize business operations. They also determine the capital structure and liquidity of the company. Long-term debts are important in determining the long-term solvency of a company. As the company becomes unable to repay its long-term debts, it is considered to be facing a solvency crisis.
Types of Liabilities
In this section, we will discuss the different types of liabilities that we find listed on the balance sheet.
Let us discuss the following three types:
1. Current liabilities
These are the short-term debt owed by the business that must be paid within the period of one year. Most of these debts are used for regular business operations. These are of the following types:
- Interest payable: This represents the amount of interest expense accrued to date but is not paid to date as per the balance sheet. That is why interest payable is also known as accrued interest. Let us understand this with an example. Suppose that the incurred interest is 20,000 rupees that are to be paid during the next fiscal year. In such a case, this journal entry will be recorded as ‘Interest payable: 1000’.
- Accounts Payable: This is another short-term liability that must be paid within one year. It is generated whenever a company purchases goods and services from its suppliers. These get reduced when the company pays off its obligations. Accounts payable is a useful metric in the balance sheet. Experts can measure the company’s liquidity using AP. It is also used in planning the cash cycle.
- Accrued expenses: These expenses are recognized at the time when they are incurred. This happens regardless of whether the fact that cash has been paid or not. There are two common types of AP: Accrued Salaries and Wages, and Accrued Interest. Warranties on products and services received, interest payments on loans, etc. are examples of accrued expenses. Once debts are paid off, the account payable account will be debited and the cash account will be credited.
- Income tax payables: Since income tax needs to be paid within the period of one year, it comes under the category of current liabilities. Other taxes are classified as long-term liabilities.
- Bank account overdrafts: The bank provides a short-term loan when the payment is processed with insufficient funds available in the bank account.
2. Non-Current/Long-Term Liabilities
These refer to financial obligations that are due in more than one year. These long-term debts can help companies with financing. Companies use these long-term debts for gaining capital for investment purposes and the purchase of assets.
The following are the different types of non-current debts:
- Bonds payable: These are recorded whenever a company issues bonds to generate cash. The act of issuing the bond creates liability. These can be issued at discount, at par, and at a premium. The pricing of a bond is dependent on the difference between the coupon rate and the market yield on the issuance.
- Deferred Tax Liability: It arises when there is a difference between the amount that the company deducts as tax and the taxes for accounting purposes. These are the taxes that have been incurred but yet not been paid. This line item on the balance sheet reserves money for a specific expense in the future. This reduces the company’s cash flow available for expenditure but still, the company can use it for paying taxes.
- Mortgage payable: It is a promissory note that is secured by an asset and the title of the asset is then pledged to the lender. It is payable in equal installments that consist of both principal and interest throughout the loan term. This is usually done for purchasing a property.
- Capital lease: It is a contract that entitles a lender to use assets on a temporary basis. This contract has economic characteristics of asset ownership for the purpose of accounting. It is also recorded on the balance sheet. The renter books assets and liabilities with the lease in case the rental contract meets certain requirements.
3. Contingent Liabilities
These are potential liabilities that may occur based on the outcome of a future event. These may or may not happen. Therefore, such debts are recorded in accounting records only if the probability of occurrence is more than 50%. Outstanding lawsuits, government probes, liquidated damages, and product warranties are examples of contingent liabilities.
A contingent liability has the potential to negatively impact the future net profitability and cash flow of a company. Therefore knowledge of the liability can help investors and creditors in making better decisions. These can also reduce profit generation for the company.
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4. Accrued liabilities
Accrued liabilities are financial obligations that a company has incurred over a specific period but has not yet paid for. These are expenses that are recognized in the company’s financial statements before they are paid.
Such liabilities represent the amounts owed by a company for goods or services that have been delivered or used but not yet invoiced by the supplier. These are recorded in the company’s books to accurately reflect the financial position at a specific point in time, even if the payment has not yet been made.
5. Equity Liabilities
- Equity liabilities refer to obligations that a company settles by issuing its own equity instruments, such as shares.
- These arise from financial contracts, agreements, or specific financing situations.
- They are settled by issuing equity instruments (e.g., common shares, preferred shares) instead of cash or other assets.
- Loans or bonds that can be converted into equity shares can lead to equity liabilities, especially if the conversion is mandatory.
- Some employee compensation plans, which commit the company to issue shares based on certain conditions or achievements, can create equity liabilities.
- Certain financial derivatives may require settlement by issuing equity, leading to an equity liability.
- Equity liabilities impact a company’s balance sheet and require careful accounting to ensure accurate financial reporting.
- Introduces variability in the number of shares outstanding, which can dilute existing shareholders’ equity.
Hope that you have learnt what is liabilities. Overall, liability is not bad since it can help in financing projects and facilitating investments. However, too much liability can cause financial harm to businesses. Businesses must have enough assets to pay off their liabilities in case of an emergency. This is why businesses must track their financial ratios to stay on track.
Is car an asset or a liability?
The car is an asset in itself since it has a market value and it is a transportation means that serves the owner. However, when the car is bought on a loan, it becomes a liability for the buyer.
Are credit cards asset or liability?
A credit card is a liability since it does not increase your net worth. Instead, you have to repay the amount to the credit card provider. This makes credit cards a liability.
What are negative liabilities?
In technical terms, a negative liability is an asset of the company. These are mostly created in error which indicates issues with the accounting system.
What does a liability account with negative sign indicate?
A liability account with a negative sign indicates that the liability account has debit balance rather than normal balance.
What causes liabilities to increase?
Loans, unearned revenues, income tax payables, and any short-term debts increase in liabilities. Any increase indicates that the company is purchasing more using credits instead of paying off liabilities.
When are current liabilities credited and debited?
Current liabilities are credited when a payment obligation or due payment is received. They are debited when the due payment is made.
Is it possible that the company has no liabilities?
Practically, it is not possible since accrued expenses are also a part of liabilities. If the accrued expenses are also zero, this will mean that the company is paying salaries to employees in advance. Theoretically, this means that the assets of the company are equal to the equity of the company.
What is liabilities vs expense?
In terms of the difference between liabilities and expenses, expenses refer to what the company pays on monthly basis for funding operations. Liabilities refer to the obligations and debts that are owed to others.