Liabilities in accounting are always on the right-hand side of a balance sheet. The different types of liabilities can be loans taken by businesses from banks or other financial entities and their failure to repay on time. Liabilities also include delayed payments of taxes, wages and mortgage debt. In the case of individuals, liabilities include delay in payment of loans obtained from banks, delay in paying taxes, or a host of other unpaid bills. You can settle liabilities in different ways. Some of these include the transfer of money and products.
Any liabilities that extend upto 12 months or less than 12 months are current or short-term liabilities. Liabilities that stretch beyond 12 months are non-current liabilities or long-term liabilities. A liability can be real or potential. A real liability, e.g. is a property bill that you have to pay. Potential liability can be the possibility of a lawsuit slapped on you by someone for a specific reason. All liabilities are legally binding upon the borrowers.
Did you know?
In 2019, Vodafone Idea reported a corporate liability of ₹50,922 crores for a specific financial quarter?
What Are Liabilities in Accounting?
The total liabilities of any organisation are the aggregate of its short-term and long-term liabilities. The simple formula to understand liabilities is as follows:
Assets: Total value of the entire premises that an organisation owns.
Equity: The stake the Founder or Founders hold in the organisation.
Liabilities – The financial obligations of the said business.
Thus, liabilities are the difference between the assets minus the equity. Liabilities in accounting include the financial obligations of a business. The obligation could be:
- A current one – is some recent unpaid taxes.
- An obligation that has occurred in the past – bank loans or mortgages.
- Settlement of the same.
Liabilities in accounting include:
- Non-current or long-term
As the name suggests, current liabilities are financial obligations that an organisation owes in the current financial year. An organisation needs to fulfil these types of liabilities before completing one year. For this reason, they are short-term liabilities. Typical examples of current liabilities are bank overdrafts, short-term loans taken by an organisation, accounts payable, dividends that need to be payable and expenditures that have accumulated and interest that we need to pay on something specific.
Non-Current or Long-term Liabilities
These are financial obligations that expect an organisation to pay beyond the timeframe of a year. When an organisation discovers it cannot settle its long-term dues, it indicates it is in a crisis. Long-term liabilities include notes payable, delayed tax settlements, bonds payable, rent obligations (lease agreement) and deferred payment towards machinery and other equipment.
These types of liabilities are self-explanatory. These arise based on some unforeseen events in the future. This could be high volatility in the global economy, which could be due to bad weather conditions like floods or drought, war-like situations, pandemics or even competition in the market space. These are based on conjecture. Some examples of contingent liabilities include lawsuits or even a product warranty.
How to Find Liabilities?
Liabilities play a vital role in the operations of any business. They give an instant understanding of the total amount of debt that a company has to settle within a year or in the future. This clarity provides a business with a better understanding of whether it should procure more loans or decide on a strategy that will boost profits. There are different ways to assess liabilities and decide on a course of action based on those details. Some of these are below:
The Importance of Organising the Liabilities
As a business house, you should collate all accounts information. This will showcase the liabilities you owe to others. Once you have the details, categorise the liabilities e.g.
Rent - ₹ 25,000
Loans taken for business - ₹800,000
Taxes to be paid - ₹1,35,000
Accounts payable - ₹85,000
You can resort to some of the professional accounting softwares, which are formulated with all the various categories. This softwares facilitate the detailing in an organised manner.
Short-term and long-term Categorisation
This categorisation will give you an insight into liabilities you have to fulfil soon and help you understand the long-term ones. These details will help you strategise your business plans for the future accordingly.
Resort to a Professional Software for Efficient Computation
You can use specific software to sum up the total assets and liabilities. Professional software eases the computations and speeds the computing processes. You will be able to get accurate numbers of your current, non-current, and contingent liabilities.
Examples of Liabilities
Trade credit, credit cards, bank overdrafts.
When you write a cheque for an amount that exceeds the revenue amount in your bank account, e.g. your business account has a balance of ₹20,000, and you issue a cheque of ₹40,000. If the bank clears your cheque, your business account has been overdrawn by ₹20,000.
Procurement of raw materials, lease payments, licence payments, and logistics.
You take a loan of ₹1,000,000 to pay at an interest rate of 6% to the financial lenders at the end of every quarter. You will have to pay ₹ 5,000 at the end of each month. This becomes the debit to the account of interest expenditure and a credit to the interest payable account.
This includes the purchase of an asset like premises, a vehicle or even a bank loan.
This includes payment of rent in advance, tickets for air travel, prepaid amount towards insurance or making a payment towards an annual subscription use of the software.
This includes expenditures for which the bank hasn’t procured any documentation.
This includes payments made based on a lease agreement, e.g. purchase of land, a vehicle, software or even distinct equipment for a computer.
This includes loans taken towards payment of loans towards purchasing a house, car, loans for a small scale business and personal loans.
This includes treasury bills and bonds.
This includes financing of projects and new infrastructure, among many others.
Delayed tax Liabilities
This includes taxes that a business owes, but the company has to make the payment at a specific time in the future.
Contingent Liabilities (some are self-explanatory)
This includes expenses connected with the repairs of defective goods or the replacement of such goods. Suppose a client files a lawsuit of ₹100 for receiving a damaged product. The legal division of the business believes that the client has concrete proof of the same. There are chances that the company may incur a liability of ₹100, and therefore it makes an entry in its financial statement. The business will record a debit in legal expenses and credit in the account of accrued costs.
This can include lawsuits for patent theft.
Let’s assume a business sells two-wheelers. It is supplying three years of proof on the engine of the same. Each engine costs ₹1,000. If the company sells about 5000 two-wheelers, it will have to estimate how many of them could come to replace the engine during the warrantied timeframe. The business will make a provision of contingent liability in its financial statement. Let’s assume that the business considers about 25% of the two-wheelers requesting an engine replacement. This would amount to 1,250 two-wheelers multiplied by the cost of each engine, i.e. ₹1,000. The contingent liability would amount to ₹1,250,000.
Changes in the Policies of the Government
If a business house believes that the chances of a change in the government policies are high, this will increase the prices of its goods.
If ABC takes a loan of ₹1,000 and XYZ offers a guarantee on that loan. If ABC cannot make the said payment, then XYZ will be accountable for the same to the said bank, and this will reflect as a contingent liability in the books of accounts of XYZ.
Changes in Foreign Exchange
This includes the impact on transactions that take place in foreign currencies.
When there is a mutual agreement of payment from one to another business entity and defaults, the non-defaulting entity can file a case to procure a judgement for the liquidated damages. The defaulter makes an entry of a contingent liability in its financial statement.
The details of this article helps understand the various types of liabilities in accounting. Every business must understand its immediate or current liabilities and its long-term or non-current liabilities. This aids a business to know how to plan for expansion and making appropriate choices for availing of more loans or continuing with the current level of liabilities.