Liability is an obligation to repay someone a sum of money. This sum of money enters into the business either when the business is commenced or during the course of the business and provides an economic benefit.
This obligation is fulfilled at the time of winding up of the company and during the due course of the business.
This is a legal obligation. The business and the owner are two different entities. Even though the business is commenced by the owner. His capital is treated in liability’s section under shareholders fund.
That’s why it is repaid to the owner. And also salary is provided to the owner only when it’s specified in the agreement.
This liability is for the sake of the business. Without capital, without resources, without paying salary, without electricity a business cannot function.
When it has to buy a big machinery or ought to make an investment. It won’t pull out money out of its reserve or earnings as those are set to meet the day-to-day requirements of the business. It has to get a loan. When it has to earn but it doesn’t have any stock. It will buy the materials on credit and once the customers pay. It will pay back out of earnings.
Difference between liability and expenditure.
For instance, to produce 10 royal shirts. Let’s assume the expenditure as Rs.50,000. If the entity does not have enough money. It will borrow Rs.50000. Now it becomes a liability to pay back.
Expense is accounted in the Profit and Loss account. It is used to perform any operation. Liability is one of its mediums.
They are categorized into two: Current and Noncurrent liability.
In this blog, we will study about current liabilities.
Current liabilities are the debts paid out within a year usually with cash and cash equivalents.
Generally short term liabilities are categorized as current liabilities as they are repaid in a short period of time.
Debt. This conveys if the entity is having enough revenue to pay its short term obligations.
Current Liabilities formula = Notes payable + Accounts payable + Accrued expenses + Unearned revenue (customer deposits)+Interests payable + Dividends payable + Current portion of long term debt +Income and sales taxes + other short term debts.
The current liabilities are as follows. According to the type of business some the listed below may/may not appear.
General when we buy a product, paying for it is our ultimate duty. At that time it is treated as an expense. If we want a credit period for 3 or 6months, then until we pay for the expense we owe some amount of money with the seller. During this period this amount comes under the Account called “Payable”. This holds the major portion of the current liabilities as this holds the maximum weightage of the inventory.
A current-long term debt:
Usually in the course of a long term debt say Notes payable. The interest/due amounts of the long term debt which are paid in parts in the current accounting year is categorized as a current part of the long term debt.
Accrued expenses are generally referred to salary/wage. This holds the expense which is not paid to the wager or to the salaried employee yet. They are called ‘accrued’ because this kind of debt accumulates over time. Therefore, It is the amount of money the employees owe for work done but is not paid to them yet and this will be paid within a short period.
When a debt is having its maturity date by the end of 1Y or 10Y or before that. We have to pay the cost of borrowing ‘interest’. This interest is a monthly obligation to pay. Short term debts are the debts which are paid before a year’s period. For example, Installments, Commercial paper, LoC, Invoice financing, Short term bank loans.etc….
A company owes money to the end customer if the company received any amount in advance for the goods to be delivered in the future date. So this debt is settled either by handing over the product or through refund.
Its the amount of money set aside from the profits to pay its shareholders but not paid yet. When it is paid out there is a debit in cash of the retained earning account. Good companies pay out dividends regularly.
People who have saving or current accounting can avail the facility of withdrawing beyond the balance. When they have insufficient or zero balance, Overdraft instrument allows a person to withdraw funds up to an agreed limit. It is a kind of loan.
Income Tax Payable:
The tax levied on the earnings of the company is referred to as Income tax here. So the taxes which are due to the government in the short run are called Income tax payable.
The tax levied on a product or service at the time of sale is treated as a liability till its paid to the government authorities.
Disclosure of Current liabilties in a company’s balance sheet
In the balance sheet of ABC & Co
|EQUITY & LIABILITIES||Rs.|
|Income and sales tax||X|
|Short term debts||X|
|Other short term liabilities||X|
|Amount to be shown in the balance sheet||XX|
What does the current liability convey?
Current liabilities are used calculate liquidity ratios such as Quick ratio, current ratio.
Current Ratio= Current assets/Current Liabilities. Here the assets should be twice or more than twice that of its liability.
Quick ratio= (Current assets-Inventory)/Current liabilities.
If its greater than one, then the company is not in a bad position and is able to meet its short term obligations. There are companies with good ratios. The assets should be twice or more than that of its liability.
Low quick and current ratios tells that a company is not having enough assets to liquidate and pay its debts off. Its often risky to invest here.
What is contingent liability? Does that account in the liability side of the balance sheet?
Contingent liability is a possible loss that might occur for which the company is responsible. The loss is uncertain and this is not yet known. As the amount cannot be shown as on the date of preparing the balance sheet. This amount is adjusted in the financial statement and then shown in the balance sheet as this debt is not payable now but can be accounted as provision in the balance sheet. Contingent liabilities are Guaranty and warranty for a product, Letter of credit, Loss.etc..