A liability is defined as an obligation of an entity arising from past transactions/events and settled through the transfer of assets.
Explain how to identify a liability
- Some of the characteristics of a liability include: a form of borrowing, personal income that is payable, a responsibility to others settled through the transfer of assets, a duty obligated to another without avoiding settlement, and a past transaction that obligates the entity.
- The IASB’s definition of a liability is: a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.
- Types of liabilities found in the balance sheet include current liabilities, such as payables and deferred revenues, and long-term liabilities, such as bonds payable.
- fiscal year: An accounting period of one year, not necessarily coinciding with the calendar year.
- obligation: A legal agreement stipulating a specified payment or action; the document containing such agreement.
- deferred: Of or pertaining to a value that is not realized until a future date (e.g., annuities, charges, taxes, income, either as an asset or liability.
Liability Definition & Characteristics
In financial accounting, a liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future. A liability is defined by the following characteristics:
- Any type of borrowing from persons or banks for improving a business or personal income that is payable in the current or long term.
- A duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services, or other transaction yielding an economic benefit due at a specified or determinable date, on occurrence of a specified event, or on demand.
- A duty or responsibility that obligates the entity to another, leaving it little or no discretion to avoid settlement.
- A transaction or event that has already occurred and which obligates the entity.
Liability Defined by the IASB
Probably the most accepted accounting definition of a liability is the one used by the International Accounting Standards Board (IASB). The following is a quotation from the International Financial Reporting Standards (IFRS) Framework: “A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. ”
Examples of Liabilities
Types of liabilities found on a company’s balance sheet include: current liabilities like notes payable, accounts payable, interest payable, and salaries payable. Liabilities can also include deferred revenue accounts for monies received that may not be earned until a future accounting period. An example of a deferred revenue account is an annual software license fee received on January 1 and earned over the course of a year. The company’s fiscal year end is May 31. For the current fiscal year, the company will earn 5/12 of the fee and the remaining amount (7/12) stays in a deferred revenue account until it is earned in the next accounting period. Long-term liabilities have maturity dates that extend past one year, such as bonds payable and pension obligations.
Two typical classification types for liabilities are current and long-term.
Differentiate between current and long-term liabities
- Current liabilities are often loosely defined as liabilities that must be paid within one year. For firms having operating cycles longer than one year, current liabilities are defined as those which must be paid during that longer operating cycle.
- Long-term liabilities are reasonably expected not to be liquidated or paid off within a year. They usually include issued long-term bonds, notes payables, long-term leases, pension obligations, and long-term product warranties.
- Contingent liabilities can be current or long-term and usually deal with legal actions or litigation claims against the entity or claims, such as penalties or fees, an organization encounters throughout the course of business.
- callable: That which may be redeemed by its holder before it matures.
- contingent: An event which may or may not happen; that which is unforeseen, undetermined, or dependent on something future; a contingency.
Types of Liabilities
Liabilities are classified in different types. The two main categories of these are current liabilities and long-term liabilities.
Current liabilities are often loosely defined as liabilities that must be paid within a single calender year. For firms with operating cycles that last longer than one year, current liabilities are defined as those liabilities which must be paid during that longer operating cycle. A better definition, however, is that current liabilities are liabilities that will be settled either by current assets or by the creation of other current liabilities.
Example of current liabilities include accounts payable, short-term notes payable, commercial paper, trade notes payable, and other liabilities incurred in the normal operations of the business. Some of these normal operating costs include salaries payable, wages payable, interest payable, income tax payable, and the current balance of a long-term debt that will be due within a single year. Other long-term obligations, such as bonds, can be classified as current because they are callable by the creditor. When a debt becomes callable in the upcoming year (or operating cycle, if longer), the debt is required to be classified as current, even if it is not expected to be called. If a particular creditor has the right to demand payment because of an existing violation of a provision or debt statement, then that debt should be classified as current also. In situations where a debt is not yet callable, but will be callable within the year if a violation is not corrected within a specified grace period, that debt should be considered current. The only conditions under which the debt would not be classified as current would be if it’s probable that the violation will be collected or waived.
Long-term liabilities are reasonably expected not to be liquidated or paid off within the span of a single year. These usually include issued long-term bonds, notes payables, long-term leases, pension obligations, and long-term product warranties.
Contingent liabilities can be current or long-term. They typically deal with legal actions or litigation claims against the entity or claims (such as penalties or fees) an organization encounters throughout the course of business. Contingent items are accrued if the claims and their likelihood of occurring are probable, and if the relevant amount of the liability can be reasonably estimated.