Meaning of Liability
Liability is a term in accounting that is used to describe any kind of financial obligation that a business has to pay at the end of an accounting period to a person or a business. Liabilities are settled by transferring economic benefits such as money, goods, or services.
They are recorded on the right-hand side of the balance sheet, which includes 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 of 12 months and long-term liabilities become due within more than 12 months.
Types of Liabilities
Liabilities can be classified into three main categories, which are:
- Current Liabilities
- Non-current Liabilities
- Contingent Liabilities
- Current Liabilities: They are liabilities that are due and need to be paid within an accounting period which is usually a year or 12 months. Current liabilities are also known as short-term liabilities due to the relatively short turnaround time.
Current liabilities need to be closely monitored by the management of a company as a company needs to have sufficient liquidity in the form of current assets to pay off the current liabilities. Current liabilities have a direct impact on the working capital and also on the liquidity of the business.
Examples of current Liabilities:
- Interest Payable.
- Accounts Payable.
- Short-term loans.
- Accrued Expenses.
- Bank Overdraft.
- Non-Current Liabilities: Which are also known as long-term liabilities are financial obligations that are due over a year. Long-term liabilities play an important role in the long-term financing of the business.
These liabilities help businesses acquire capital assets by providing the required capital. Businesses can also invest in new capital projects using the funds obtained from long-term debts or liabilities.
Long-term liabilities are an important indicator of the solvency of the business. A company that is unable to pay off long-term liabilities as and when they become due, indicates a solvency issue with the business or signals a crisis within the business. Investors always look at the long-term liabilities of the business before investing.
Examples of Long-term Liabilities:
- Deferred tax liabilities.
- Bonds payable.
- Capital leases.
- Contingent liabilities: They are a special type of liability that may occur during a business, depending on the outcome of an event that may take place in the future. In accounting standards, contingent liabilities are recorded as potential or probable liabilities only if they have a 50% chance of occurring and when the amount of liability can be estimated properly.
Examples of Contingent Liabilities:
- Product Warranties.