A legal obligation of a company
A legal obligation of a company
A liability is a financial obligation of a company that results in the company’s future sacrifices of the economic benefits to other entities or businesses. A liability can be an alternative to equity as a source of a company’s financing. Moreover, some liabilities such as accounts payable or income taxes payable are essential parts of day-to-day business operations.
Liabilities can help the companies organize successful business operations and accelerate value creation. However, poor management of the liabilities may result in significant negative consequences such as a decline in financial performance or worse, bankruptcy.
In addition, the liabilities determine the company’s liquidity and capital structure.
A company reports its liabilities on a balance sheet. According to the accounting equation, the total amount of the liabilities must be equal to the difference between the total amount of the assets and the total amount of the equity.
Assets = Liabilities + Equity
Liabilities = Assets – Equity
Liabilities must be reported according to the accepted accounting principles. The most common accounting standards are the International Financial Reporting Standards (IFRS). The standards are adopted by many countries around the world. However, many countries also follow their own reporting standards such as the GAAP in the U.S. or the RAP in Russia. Although the recognition and reporting of the liabilities comply with different accounting standards, the main principles are close to the IFRS.
On a balance sheet, liabilities are listed according to the time when the obligation is due.
The primary classification of liabilities is according to their due date. The classification is critical to the company’s management for a proper control of the financial obligations.
Current liabilities are the liabilities that are due within a year. This type of the liabilities is primarily used in regular business operations. Due to the short-term nature of the financial obligations, current liabilities should be managed with consideration of the company’s liquidity. Liquidity is frequently determined as a ratio between current assets and current liabilities. The most common current assets are:
Long-term (non-current) liabilities are the liabilities that are due after more than one year. It is important that the long-term liabilities exclude the amounts that are due in the short-term, such as interest payable, which are current liabilities.
Long-term liabilities can be a source of financing, as well as refer to amounts that arise from business operations. For example, bonds or mortgage can be used to finance the company’s projects that require a large amount of financing. At the same time, the deferred tax payable or capital leases arise from the specifications of the business operations. The liabilities are critical to the understanding of the overall liquidity and capital structure of a company.
Long-term liabilities include:
Contingent liabilities are a special type of liabilities. They are the probable liabilities that may arise depending on the outcome of the uncertain future event.
A contingent liability is recognized only if both following conditions are met:
If one of the conditions is not satisfied, a company does not report a contingent liability on the balance sheet. However, it should disclose this item in a footnote on the financial statements.
One of the most common examples of the contingent liabilities is legal liabilities. Suppose that a company is involved in the litigation process. Due to the stronger evidence provided by the opposite party, the company expects to lose the case in court, which will result in legal expenses. The legal expenses may be recognized as the contingent liabilities because:
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