In the subject of financial accounting, the term liability is defined as one’s obligation to fulfill an entity resulting from previous transactions or events. To settle the obligation, the one held liable has to use or transfer assets or provide services that will economically benefit the other party in the future. There are critical characteristics that liabilities must have.
Main Characteristics of Liabilities
A liability can be identified as any borrowings made by persons, firms, or banks with the aim of improving businesses or one’s personal income and that one should pay either in the short or long term. The second characteristic is that one the borrowing party has the obligation to the lending party to settle the liability by providing future services of economic value or by transferring or using assets. This should be made possible on a predetermined date, a specified occurrence or event, or when demanded. Lastly, the borrower is obligated towards the other entity and is at little or no discretion not to meet the settlement.
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Importance of Classifying Liabilities
Liabilities are classified into two categories; short-term liabilities which are also known as current liabilities and long term liabilities. Current liabilities are those that should be settled within a year of the balance sheet’s date and that may be renewed or will require cash payment. A firm, individual or bank has to know its short-term liabilities so that it may be able to know its current assets from the accounting equation which dictates that assets are a sum of liabilities and capital. Current assets are important to know as they can easily liquefy to cash.
Examples of Liabilities
Examples of current liabilities include a short-term bank loan, account payables such as creditors, prepaid incomes, and accrued expenses. Examples of long term liabilities include a five-year loan and debentures.
