Liability: Definition, Types, Example, and Assets vs Liabilities

Chapter 10 addresses the ways in which a corporation can raise funds by issuing shares, known as equity financing. This chapter discusses corporate financing by means of issuing long-term debt, known as debt financing. Types an estimated liability of long-term debt are typically classified according to their means of repayment. Retirement plans are not the only liability that must be estimated. Employee healthcare and product warranty programs work the same way as pension funds. Again, statistics is used to reasonably estimate a defect percentage and the estimated liability is then reported in the financial statements.

Assets are what a company owns or something that’s owed to the company. They include tangible items such as buildings, machinery, and equipment as well as intangibles such as accounts receivable, interest owed, patents, or intellectual property. Liabilities are categorized as current or non-current depending on their temporality.

LO2 – Record and disclose known current liabilities.

Below are examples of metrics that management teams and investors look at when performing financial analysis of a company. The primary classification of liabilities is according to their due date. The classification is critical to the company’s management of its financial obligations.

1. AT&T clearly defines its bank debt that’s maturing in less than one year under current liabilities.
2. Historical data indicates that warranty costs average 2% of the cost of sales.
3. We’re going to do the same thing here, except we’re talking about warranties.
4. For the seller, the discount amount of $32,520 () is then amortized over the life of the bond issuance using the effective interest rate method.
5. Tax liability can refer to the property taxes that a homeowner owes to the municipal government or the income tax they owe to the federal government.
6. These rights are printed on the actual certificate and vary among bond issues.

The loan bears interest at 6% per year on the unpaid balance and is repayable in three annual blended payments of $18,705 on December 31 each year. Liabilities are obligations that are owed, and while most liability amounts are known, there are some Jan will need to estimate to complete the balance sheet. Estimated liabilities represent the recognition of probable future charges that result from a prior act (the estimated liability for warranties, trading stamps, or coupons). Imagine a company called “ElectroGadgets” that manufactures and sells electronic goods like smartphones and laptops. They offer a one-year warranty on all their products, promising to repair or replace any defective items within that period.

Do you own a business?

1. Payment of interest is made when the bearer clips coupons attached to the bond and presents these for payment.
2. The corporation issuing bonds may be required to restrict its retained earnings.
3. Corporations generally acquire long-lived assets like property, plant, and equipment through the issue of shares or long-term debt that is repayable over many years.
4. At best, her calculations may be overestimated since some employees who are eligible to retire may not.

This permits a large number of individuals and institutions to participate in corporate financing. Shareholder approval is an important step because bondholders are creditors with a prior claim on the corporation’s assets if liquidation occurs. Further, dividend distributions may be restricted during the life of the bonds, and those shareholders affected usually need to approve this. These restrictions are typically reported to the reader of financial statements through note disclosure. A contingent liability is a potential liability (and a potential loss or potential expense).

A short-term note payable is identical to a note receivable except that it is a current liability instead of an asset. In Chapter 7, BDCC’s customer Bendix Inc. was unable to pay its $5,000 account within the normal 30-day period. The receivable was converted to a 5%, 60-day note receivable dated December 5, 2023.

Details of the loan would be disclosed in a note to the financial statements. Only the principal amount of the loan is reported on the balance sheet. The interest expense portion is reported on the income statement as an expense. Because these loan payments are made at BDCC’s year-end, no interest payable is accrued or reported on the balance sheet. While most liability amounts are known, there are some that need to be estimated, such as retirement, warranties and property taxes. Property taxes are considered estimated liabilities because a property’s value can change, which causes the local government to adjust tax rates.

Companies estimate warranty liabilities, classified as contingent liabilities, to match expenses with revenues per the matching principle. For instance, if a company anticipates warranty costs at 4% of $2,000,000 in sales, the warranty expense would be $80,000. This amount is recorded as a liability, ensuring accurate financial reporting.

Which of these is most important for your financial advisor to have?

For a contingent liability to become an actual liability a future event must occur. Liabilities can help companies organize successful business operations and accelerate value creation. However, poor management of liabilities may result in significant negative consequences, such as a decline in financial performance or, in a worst-case scenario, bankruptcy. Rosedale Corp. obtained a $50,000 loan from Second Capital Bank on January 1, 2019. It purchased a piece of heavy equipment for $48,000 on the same day.

The various characteristics applicable to bond issues are the subject of more advanced courses in finance and are not covered here. LO1 – Identify and explain current versus long-term liabilities. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Furthermore, in many cases, the actual payee of the liability is not known until the future event occurs.

Definition of an Estimated Liability

These premiums and discounts are amortized using the effective interest method over the same number of periods as the related bonds are outstanding. The amortization of premiums and discounts is an intermediate financial accounting topic and is not covered here. Lastly, property taxes are also considered an estimated liability.