Tuesday, 23 September 2014

What is a liability? Nature and Classification of Liabilities

Liability is something which a person owes to another. It is an obligation which can be the result of some activity or transaction entered into by the two parties.

Sometimes, a liability can be merely a responsibility or sense of feeling shown by one person to another in lieu of sheer love or gratitude. For example, performing the marriage of a daughter or donating money to some social cause periodically or even frequently can be felt as a liability.

But, for the accounting purpose, a liability can be defined as an obligation or responsibility of a person or any business entity to the other party to any transaction or contract. It is some unavoidable obligation to be fulfilled by the party concerned to his creditors or other parties on the maturity of some period or on an occurrence of some event or on the achievement of some goal or target.

Classification of Liabilities

Liabilities are generally treated as of three major types:
1) Current Liabilities
2) Long-term Liabilities
3) Contingent Liabilities

Now let us have a look at the nature and identification of these three classes of liabilities.

Current Liabilities
Current liabilities are also known as short-term liabilities due to its short period nature. A current liability signifies the priority involved in clearance of the liability. Such liability is considered to be cleared within some short period, say within 3 months or 6 months. You will have to clear them within that short range of period. Some of them may even become due within days, say within 3 days, 7 days, or a month like that. Any type of borrowing or credit taken to meet your daily requirements of business fall under this category and they require being cleared first. Salaries and taxes payable are such urgently payable short-term liabilities. Besides, Bank overdraft, short-term credits like credit cards, credit purchases are also examples for this category.

Long-Term Liabilities 
From the name itself, you are able to see that these liabilities are of long-term or for longer durations. Normally such liabilities are cleared in many years and the terms of repayments are set forth at the time of obtaining the fund or during execution of the contract. Bank loans for long periods, mortgages, etc. fall under this category.

Contingent Liabilities 
This category of liability is dependant on some contingency. That is, its clearance is related to the occurrence of an event or incident. If a such and such event takes place, it becomes due to be paid immediately upon that happening. If the stated incident does not take place at all it will not be required to be cleared. So it is a contingent liability, meaning that it will be paid only on the occurrence of a certain incident which is not known or not certain when it may take place. Some other unexpected incidents like a breach of contract, damage due to accidents and/ or court cases are also cases of contingent liability.

For accounting purpose, only current liabilities and long-term liabilities are considered in the Balance sheets. Contingent liabilities are merely mentioned in the notes as a supplementary to the Balance Sheet for the information of Board of Directors and Share-Holders.

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