Definition: Liability, as the name suggests, is a legal obligation which reflects an amount that the company owes to outside parties, i.e. banks, financial institutions, individuals or entities, whose settlement may lead to the outflow of the firm’s economic resources.
In finer terms, liabilities are a company’s financial debts, which indicates creditors claim on business assets that need to be paid off when they become due for payment. These liabilities arise as a result of past events, i.e. to acquire a long term asset, to start another unit or to improve business operations.
The liabilities appear in the first part of the balance sheet, as “equity and liabilities“. The capital contributed by the owners is commonly called as internal liability, whereas the liability paid to the outside parties is considered as an external liability. External liability occurs out of credit transactions or funds raised by the firm from external parties.
Classification of Liabilities
On the basis of the holding period, liabilities are classified as:
- Non-current Liabilities: Otherwise called as long-term liabilities, these are the debt owed by the company for a long period, which implies that it will become due after a year. These are one of the significant source of funds for the enterprise that they acquire to fulfil their immediate cash requirements of buying a capital asset or invest in new projects.
- Long-term borrowings: Long-term borrowing implies the amount owed by the company to outside parties, for a term, more than a year. It includes mortgage bonds, debentures, bonds payable, term loan, long term notes payable. The long term debt of a company decides its leverage and solvency position.
- Other long-term liabilities: It refers to the financial obligations which become due for payment after one year, such as capital lease, pension or post-retirement benefits to employees, workmen compensation fund, employee provident fund, etc.
- Deferred tax liabilities: It implies the tax liability of the organisation, for the present financial year.
- Long-term provisions: Long term provision represents the amount kept aside by the firm to fulfil, any anticipated obligation, whose amount is uncertain and the period of occurrence is also not known.
- Current Liabilities: These are short term liabilities which are expected to be repaid in the enterprise’s regular operating cycle, i.e. within one year. These determine the company’s liquidity position as they play a crucial role in working capital management of the enterprise.
- Short-term borrowings: These are the obligations which fall due for payment within a period of one year. It includes bank overdraft, short term loans and advances, etc.
- Trade payables: It refers to the amount payable by the firm to the suppliers for raw material delivered or services consumed during a financial year. It includes bills payable and creditors.
- Other current liabilities: The financial obligations which become due for payment during the normal operating cycle, comes under other current liabilities. It includes lease payments, interest payable, accrued expenses, and so forth.
- Short term provisions: It covers the amount kept aside, for future expected liability, that fall due within a year.
- Contingent liabilities: These liabilities are not actual liabilities, but they can turn out as actual liability as a result of happening of certain future events. And so, if these events fail to occur, no such liability will arise. Hence, in better words, it is a potential obligation whose occurrence depends on the outcome of a future event. These do not appear in the balance sheet; instead, it is an off-balance sheet item, as it appears as a footnote.
Therefore, liability is the claim of the individuals or entities other than the owners of the enterprise, which is denoted by assets less owner’s equity.