Liabilities: Meaning, Characteristics and Measurement

In this article we will discuss about Liabilities:- 1. Meaning and Nature of Liabilities 2. Characteristics of Liabilities 3. Measurement 4. Classification 5. Equity and Liabilities.

Meaning and Nature of Liabilities:

Liabilities may he defined as currently existing obligations which a business enterprise intends to meet at some time in future. Such obligations arise from legal or managerial considerations and impose restriction on the use of assets by the enterprise for its own purposes. Liabilities are obligations resulting from past transactions that require the firm to pay money, provide goods, or perform services in the future.

The existence of a past transaction is an important element in the definition of liabilities. For example, if a buyer gives a purchase commitment to a seller, this is only an agreement between a buyer and seller to enter into a future transaction. The performance of the seller that will create the obligation on the part of the buyer is, at this point, a future transaction. Therefore, such a purchase commitment is not a liability.

Accounting Principles Board of USA defines liabilities as “economic obligations of an enterprise that are recognised and measured in conformity with generally accepted accounting principles. Liabilities also include certain deferred credits that are not obligations but that are recognised and measured in conformity with generally accepted accounting principles”.

Financial Accounting Standards Board defines liabilities as follows:

“Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or services.”

Characteristics of Liabilities:

According to Institute of Chartered Accountants of India, liability is “the financial obligation of an enterprise other than owners’ funds”.

Liabilities possess the following characteristics:

(1) Occurrence of a Past Transaction or Event:

The obligations must arise out of some past transaction or event. A liability is not a liability of an enterprise until something happens to make it a liability of that enterprise.

The kinds of transactions and other events and circumstances that result in liabilities are the following Acquisition of goods and services, impositions by law or governmental units, and acts by an enterprise that obligate it to pay or otherwise sacrifice assets to settle its voluntary non-reciprocal transfers to owners and others.

In contrast, the act of budgeting the purchase of a machine and budgeting the payments required to obtain it results neither in acquiring an asset nor in incurring a liability. No transaction or event has occurred that gives the enterprise access to or control of future economic benefit or obligates it to transfer assets or provide service to another entity.

Many agreement specify or imply how a resulting obligation is incurred. For example, borrowing agreement specify interest rates, periods involved and timing of payments, rental agreements specify rental and periods to which they apply. The occurrence of the specified event or events results in a liability.

Transactions or events that result in liabilities imposed by law or governmental units also are often specified or inherent in the nature of the statute or regulation involved. For example, taxes are commonly assessed for calendar or fiscal years, fines and penalties stem from infraction of the law or failure to comply with provisions of law or regulations, damages result from selling defective products.

(2) Required Future Sacrifice of Assets:

The essence of a liability is a duty or requirement to sacrifice assets in the future. A liability requires an enterprise to transfer assets, provide services or otherwise expend assets to satisfy a responsibility it has incurred or that has been imposed on it.

Most liabilities presently included in financial statements qualify as liabilities because they require an enterprise to sacrifice assets in future. Thus, accounts and bills payable, wages and salary payable, long term debt, interest and dividends payable, and similar requirements to pay cash apparently qualify as liabilities.

(3) Obligations of a Particular Enterprise:

Liabilities are in relation to specific enterprises and a required future sacrifice of assets is a liability of the particular enterprise that must make the sacrifice. Most obligations that underline liabilities stem from contracts and other agreements that are enforceable by courts or from governmental actions that they have the force of law, and the fact of an enterprise’s obligation is so evident that it is often taken for granted.

(4) Liabilities and Proceeds:

An enterprise commonly receives cash, goods or services by incurring liabilities and that which is received is often called proceeds, especially if cash is received. Receipt of proceeds may be evidence that an enterprise has incurred one or more liabilities, but it is not conclusive evidence.

Proceeds may be received from cash sales or by issuing ownership shares—that is, from revenues or other sales of assets or from investment by owners —and enterprises may incur liabilities without receiving proceeds, for example, by imposition of taxes.

The essence of a liability is a legal, equitable or constructive obligations to sacrifice economic benefits in the future rather than whether proceeds were received by incurring it. Proceeds themselves are not liabilities.

(5) Discontinuance of Liability:

A liability once incurred by an enterprise remains a liability until it is satisfied in another transaction or other event or circumstances affecting the enterprise. Most liabilities are satisfied by cash payments.

Others are satisfied by the enterprise’s transferring assets or providing services to other entities, and some of those—for example, liabilities to provide magazines under a prepaid subscription agreement—involve performance to earn revenues. Liabilities are also sometimes eliminated for forgiveness, compromise or changed circumstances.

(6) Capital and Dividend:

Capital invested by the owner or shareholders in an enterprise is not regarded as an external liability in financial accounting. But shareholders have a right at law to the payment of a dividend once it has been declared.

As a result, unpaid or unclaimed dividends, are shown as current liabilities. It is the practice to show proposed dividends as current liabilities also, since such proposed dividends are usually final dividends for the year which must be approved at the annual general meeting before which the accounts for the year must be laid.

Measurement of Liabilities:

Liabilities are measured in conformity with the cost principle. When an obligation is created initially, the amount of liability is equivalent to the current market value of the resources received when the transaction occurs. In most cases, liabilities are measured, recorded and reported at their principal amounts.

In other words, liabilities should be measured and shown in the balance sheet at the money amount, necessary to satisfy an obligation Interest included in the face amount of accounts payable is deducted from the face amount when reporting the liability in the balance sheet.

If liabilities are not valued at cost, they can be valued at the fair market value of goods or services to be delivered. For example, an automobile dealer who sells a car with a one year warranty must provide parts and services during the year. The obligation is definite because the sale of the car has occurred, but the amount must be estimated.

In historical accounting, liabilities appear on the balance sheet as the present value of payments to be made in future. It is significant to observe that liabilities appear at the amount payable because the difference between the amount ultimately payable and its present value is immaterial.

It is only as the maturity date of liabilities is longer that there can be difference between historical or cost value (value as per the contract creating the obligation) and present value of future payment.

Liabilities may be valued:

(i) At their historic value in accordance with accounting conventions, that is, at the value attached to the contractual basis by which they were created.

(ii) At their discounted net values in accordance with the manner of valuing assets, generally recognised in economics.

While accounting conventions dictate that the valuation of liabilities should be based on the sum which is payable, it is accounting practice to make a distinction between current and long term liabilities. As regards current liabilities, there is little difference between the discounted net value and the contractual value of liabilities. In this connection, current liabilities are defined as those which will mature during the course of the accounting period.

The gap between the two methods of valuation is significant as regards long term liabilities. Long-term liabilities are valued on the basis of their historical value, that is, by reference to the contract from which they originated, and hence during periods of inflation or where the interest payable is less than the current market rate of interest, the accounting valuation will certainly be overstated by comparison with the discounted net value.

Valuation and recognition of liabilities is necessary for income determination and capital maintenance and ascertainment of a business enterprise’s financial position. Failure to record a liability in an accounting period means that expenses have not been fully recorded. Thus, it leads to an understatement of expenses and an overstatement of income. Liabilities should be recorded, as stated earlier, when an obligation occurs.

When there is a transaction that creates obligation for the company to make future payments, a liability arises and is recognised as when goods are bought on credit. However, current liabilities often are not represented by a direct transaction. This is the reason that some unrecorded liabilities are recorded at the end of accounting period through adjusting entries such as salaries, wages and interest payable.

Other liabilities that can only be estimated, should also be recognised by adjusting entries such as taxes payable. In fact, the requirement for an accurate measure of the financial position and financial structure should determine the basis for liability valuation. Their valuation should be consistent with the valuation of assets and expenses.

The need for consistency arises from the objectives of liability valuation, which are similar to those of asset valuation. Probably the most important of these objectives is the desire to record expenses and financial losses in the process of measuring income. However, the valuation of liabilities should also help investors and creditors in understanding the financial position.

The valuation of liabilities is part of the process of measuring both capital and income, and is important to such problems as capital maintenance and the ascertainment of a firm’s financial position. According to Borton, “the requirements for an accurate measure of the financial position and financial structure should determine the basis for liability valuation. Their valuation should be consistent with the valuation of assets and expenses.”

The need for consistency arises from the objectives of liability valuation, which are similar to those of asset valuation. Probably the most important of these objectives is the desire to record expenses and financial losses in the process of measuring income. However, the valuation of liabilities should also assist investors and creditors in understanding the financial position.

Classification of Liabilities:

Liabilities are generally classified as follows:

(1) Current Liabilities

(2) Long term Liabilities

(1) Current Liabilities:

Concept:

Current liabilities are those that will be paid from among the assets listed as current assets. Current liabilities are debtor obligations payable within one year of the balance sheet date. However, if a firm’s operating cycle exceeds a year, current liabilities are those payable within the next cycle.

The Committee on Accounting Procedure of the AICPA defined current liabilities as follows:

“The term current liabilities is used principally to designate obligations whose liquidation is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current liabilities.”

Current liabilities tend to be fairly permanent in the aggregate, but they differ from long term liabilities in several ways.

The main distinctive features are:

(1) They require frequent attention regarding the refinancing of specific liabilities;

(2) They provide frequent opportunities to shift from one source of funds to another; and

(3) They permit management to vary continually the total funds from short term sources.

One of the major differences between the definition of current assets and the definition of current liabilities is that the current portion of long term debt is reclassified each year as a current liability, and the current portion of fixed assets is not.

The reason for this difference is found in the conventional emphasis on liquidity and the effect on cash and cash flows; the current portion of long term debt will require current cash or cash becoming available, but the current depreciations is only indirectly related to any obligations or cash flows during the current period.

(2) Long-Term Liabilities:

Long-term liabilities are those liabilities that are not due during the next year or during the normal operating cycle. That is, long-term liabilities become due after one year and are the liabilities which are not classified as current liabilities.

Long-term liabilities are often incurred when assets are purchased, large amounts are borrowed for replacement, expansion purposes etc. Examples of long-term liabilities are debentures and bonds, mortgages, long-term notes payable, other long-term obligations.

A borrowing company while borrowing or incurring a long- term liability mortgages its assets to the lender (e.g., bondholders and debenture-holder) as a security for the liability. A long-term liability supported by a mortgage is a secured debt. An unsecured debt is one for which the creditor relies primarily on the integrity and general power of the borrower.

Contingent Liabilities:

A contingent liability is not a legal or effective liability; rather it is a potential future liability. The amount of a contingent liability may be known or estimated. Contingent liabilities are those which will arise in the future only on the occurrence of a specified event. Although they are based on past contractual obligations, they are conditional rather than certain liabilities.

Thus, guarantee given by the firm are contingent liabilities rather than current liabilities If a holding company has guaranteed the overdraft of one of its subsidiary companies, the guarantee is payable only in the event of the subsidiary company being unable to repay the overdraft. Contingent liabilities are not formally recorded in the accounts system, but appear as footnotes to me balance sheet.

Owner’s Equity:

Equity is a residual claim—a claim to the assets remaining after the debts to creditors have been discharged. Equity is the residual interest in the assets of an entity that remains after deducting its liabilities. In other words, ownership equity is the excess of total assets over total liabilities. It represents the book value of the owners’ interest in the business enterprise.

The terms owners’ equity, proprietorship, capital and net worth are used interchangeably. However, the term net worth is not considered good terminology because it gives an impression of value or current worth whereas most assets are not recorded in the balance sheets at current value or worth but at original cost.

Differences exist in accounting for the owners’ equity among a sole proprietorship, partnership and company form of organisation. In a sole proprietorship, a single capital account is needed as the owner is one, to record additional capital given by the proprietor, net profit, net losses, and withdrawals by the proprietor.

Similarly, in partnership, capital and drawings accounts are maintained for each partner separately. In company form of organisation, accounting for the owners’ (shareholders) equity is somewhat more complex than for other types of business organisations. Accounting for a company equity focuses on the distinction between capital contributed by shareholders and retained earnings.

Equity and Liabilities:

Assets are probable future economic benefits owned or controlled by the enterprise. Liabilities and equity are mutually exclusive claims to or interest in the enterprise’s assets by entities other than the enterprise.

In a business enterprise, equity or the ownership interest is a residual interest, remaining after liabilities are deducted from assets and depending significantly on the profitability of the enterprise. Distributions to owners are discretionary, depending on its effect on owners after considering the needs of the enterprise and restrictions imposed by law, regulations, or agreement.

An enterprise is generally not obligated to transfer assets to owners except in the event of the enterprise’s liquidations. In contrast, liabilities once incurred, involve non-discretionary future sacrifices of assets that must be satisfied on demand, at a specified or determinable date, or on occurrence of a specified event, and they take precedence over ownership interest.

Although the line between equity and liabilities is clear in concept, it may be obscured in practice. Often several kinds of securities issued by business enterprises seem to have characteristics of both liabilities and equity in varying degrees or because the names given to some securities may not accurately describe their essential characteristics.

For example, convertible debt have both liability and residual interest characteristics, which may create problems in accounting for them. Preference share also often has both debt and equity characteristics and some preference shares may effectively have maturity amounts and dates at which they must be redeemed for cash.