A liability is a debt assumed by a business entity as a result of its borrowing activities or other financial obligations (such as funding pension plans for its employees). Liabilities are paid off under either short-term or long-term arrangements. The amount of time allotted to pay off the liability is typically determined by the size of the debt; large amounts of money usually are borrowed under long-term plans.
Payment of a liability generally involves payment of the total sum of the amount borrowed. In addition, the business entity that provides the money to the borrowing institution typically charges interest, figured as a percentage of the amount that has been lent.
A company's liabilities are critical factors in understanding its financial status. The company's liability status also enters into every transaction related to obtaining loans or leases on equipment.
TYPES OF LIABILITIES
Current liabilities are short-term financial obligations paid off within one year or one current operating cycle, whichever is longer. (A normal operating cycle, while it varies from industry to industry, is the time from a company's initial investment in inventory to the time of collection of cash from sales of that inventory or of products created from that inventory.) Typical current liabilities include such accrued expenses as wages, taxes, and interest payments not yet paid; accounts payable; short-term notes; cash dividends; and revenues collected in advance of actual delivery of goods or services.
Economists, creditors, investors, and other members of the financial community all regard a business entity's current liabilities as an important indicator of its overall financial health. One indicator associated with liabilities often studied is working capital. The term refers to the dollar difference between a business's total current liabilities and its total current assets. Another barometer is the current ratio. Creditors and others compute the current ratio by dividing total current assets by total current liabilities, which provides the company's ratio of assets to liabilities. For example, a company with $1.5 million in current assets and $500,000 in current liabilities would have a three-to-one ratio of assets to liabilities.
Liabilities not paid off within a year (or within a business's operating cycle) are known as long-term or noncurrent liabilities. These often involve large sums of money necessary to undertake opening of a business, major expansion of a business, replace assets, or make a purchase of significant assets. Such debt typically requires a longer period of time to pay off. Examples of long-term liabilities include notes, mortgages, lease obligations, deferred income taxes payable, and pensions and other post-retirement benefits.
When debt classified as long-term is paid off within the next year, the amount of that paid-off liability should be reported by the company as a current liability in order to reflect the expected drain on current assets. An exception to this rule comes into effect if a company decides to pay off the liability through the transfer of noncurrent assets that have been previously accumulated for that very purpose.
A third kind of liability accrued by companies is known as a contingent liability. The term refers to instances in which a company reports that there is a possible liability for an event, transaction, or incident that has already taken place; the company, however, does not yet know whether a financial drain on its resources will result. It also is often uncertain of the size of the financial obligation or the exact time that the obligation might have to be paid.
Contingent liabilities often come into play when a lawsuit or other legal measure has been taken against a company. An as yet unresolved lawsuit concerning a business's products or service, for example, would qualify as a contingent liability. Environmental cleanup and/or protection responsibility sometimes falls under this classification as well if the monetary impact of new regulations or penalties on a company is uncertain.
Companies are legally bound to report contingent liabilities. These are typically recorded in notes attached to a company's financial statement rather than as an actual part of the financial statement. If a loss due to a contingent liability is seen as probable, however, it must be included as part of the company's financial statement.
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