FINANCIAL LIABILITY: CHARACTERISTICS AND EXAMPLES - DUDAS - 2024

A financial liability is any future sacrifice of economic benefits that an entity must make as a result of its past transactions or any other activity in the past. Future sacrifices to be made by the entity may be in the form of money or a service owed to the other party.

Therefore, it is a contractual obligation to deliver a cash or similar amount to another entity within a specified period. It is a potentially unfavorable exchange of assets or liabilities with another entity.

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The financial liabilities of a company are like a person's credit cards. They are very useful in the sense that the company can use the money of others to finance its own activities related to the business for a period of time that will last only until the liability is due.

However, it should be noted that excess financial liabilities can affect the balance sheet and bring the company to the brink of bankruptcy.

characteristics

Financial liabilities can generally be legally enforceable due to a previously signed agreement between two entities. However, they are not always necessarily legally enforceable.

They can be based on equitable obligations, such as a duty that is based on ethical or moral considerations.

They can also be binding on the entity as a result of a productive obligation, which means an obligation that is committed by a set of circumstances in a particular situation, as opposed to a contractual obligation. Financial liabilities basically include:

- Debts and interest payable, which are the result of using the money of others in the past.

- Accounts payable to third parties, which are the result of past purchases.

- Rent and lease payable to the owners of the space, which are as a result of the use of the property of others in the past.

- Taxes payable, arising from business results obtained in the past.

Types of financial liabilities

Liabilities are classified into two types, according to the period of time within which they expire and are subject to being paid to creditors. Based on this criterion, the two types of liabilities are:

Short-term liabilities

Short-term or current liabilities are those that are paid over a period of one year, or within the next 12 months, from the moment the company receives the economic benefit.

That is, the liabilities that belong to the current year are called short-term liabilities or current liabilities.

For example, if a company has to pay annual rent by virtue of occupying land, office space, etc., that rent will be categorized into short-term liabilities.

Likewise, the interest payable and the part of the long-term debt that will be paid in the current year will be included in the short-term liability.

Other short-term liabilities include payroll expenses and accounts payable, which include money owed to vendors, monthly utilities, and similar expenses.

Long term passives

Long-term liabilities are those that are paid over a period of time greater than one year.

For example, if a company takes out a mortgage to pay it off over a 10-year period, it will become a long-term liability.

Similarly, any debt that is not due within the current year will also be classified as a long-term liability.

For most companies, long-term liabilities primarily comprise long-term debt that is often repaid in terms even longer than a decade.

Other items that can be classified as long-term liabilities include obligations, loans, deferred tax liabilities, and pension obligations.

Short and long term liabilities

In the event that a company has a short-term liability that it is seeking to refinance, it is likely that some confusion will arise regarding its classification. To clear up this confusion, it is necessary to identify if there is any intention to refinance and also if the refinancing process has begun.

If so, and if the refinanced short-term liabilities (debt in general) will expire in a period of more than 12 months due to the refinancing, they may very well be reclassified as long-term liabilities.

Therefore, there is only one criterion that forms the basis of this classification: the next year or the 12-month period.

Examples

When a company makes a cash deposit with a bank, the bank records a liability on its balance sheet, which constitutes the obligation to reimburse the depositor, usually upon request. At the same time, according to the principle of double entry, the bank also performs the registration as an asset of the cash itself.

On the other hand, when the company deposits the cash in the bank, it registers a decrease in its cash and the corresponding increase in the bank deposit asset.

-Current liabilities

Debts to pay

These are the unpaid invoices to the company's suppliers. In general, accounts payable are the largest current liability for most companies.

Wages to pay

The total amount of earned income that employees have earned, but have not yet received. Since most companies pay their employees every two weeks, this liability changes frequently.

Interest to pay

Businesses, like individuals, often use credit to purchase goods and services to finance themselves in short periods. This represents the interest on short-term credit purchases to pay.

Dividends payable

For companies that have issued shares to investors and pay a dividend, it represents the amount owed to shareholders after the dividend is declared.

-Long term passives

Guarantee liability

Some liabilities are not as accurate as accounts payable and must be estimated. It is the estimated amount of time and money that can be spent on repairing products with the agreement of a warranty.

This is a common liability in the auto industry, as most cars have long-term warranties that can be expensive.

Lawsuits to pay

This is another liability that is estimated and requires further scrutiny. If a claim is considered probable and foreseeable, an estimated cost of all court and attorney fees will be recorded. These are common liabilities for pharmaceutical and medical manufacturers.

References

1. Dheeraj Vaidya (2019). Financial Liabilities - Definition, Types, Ratios, Examples. Wall Street Mojo. Taken from: wallstreetmojo.com.
2. Wikipedia, the free encyclopedia (2019). Liability (financial accounting). Taken from: en.wikipedia.org.
3. Will Kenton and Adam Hayes (2019). Liability Definition. Taken from: investopedia.com.
4. CFI (2019). Liability. Taken from: corporatefinanceinstitute.com.
5. Accounting Coach (2019). What is a liability? Taken from: accountingcoach.com.