Liabilities Examples in Accounting

There are various liabilities examples or types that fall under different categories incurred by individuals, small businesses, and companies. In this article, we shall look at the various types of liabilities and also give some liabilities examples that fall under each type.

What are liabilities in accounting?

Liabilities in accounting refer to financial obligations of a company or a business that results in the sacrifices of economic benefits to other entities or businesses. These sacrifices result from past events or past transactions. Simply put, the term means legal obligations that are payable to a third party. In other words, they are the financial responsibilities of a business. In accounting, they are also known as payables.

A liability can be an alternative to shareholders’ equity as a source of finance for a company. Some liabilities such as accounts payable, income taxes payable, etc, are essential parts of the business’s daily operations. Liabilities are recorded in the general ledger in a liability-type account that has a natural credit balance. They are found on a company’s balance sheet, a common financial statement that is generated through financial accounting software.

Every business has liabilities except those that solely operate with cash. By operating with cash, one will need to both pay with and accept it either with cash or through the business’s checking account.

Liabilities are helpful to a company when it comes to organizing successful business operations as well as the acceleration of value creation. However, poor management of liabilities may bring about significant negative consequences such as declining financial performance or bankruptcy.

The balance sheet contains sections that comprise assets, liabilities, and shareholders’ equity. With this, the relationship between the three components is expressed by the fundamental accounting equation. This equation states that the assets of a company are financed either with debt or equity. Unlike the assets section which comprises items that are considered to be cash outflows (uses), the liabilities section comprises items that are deemed to be cash inflows (sources).

The liabilities that a company undertakes should theoretically be offset by the value creation from the utilization of the assets that are purchased. Alongside the shareholders’ equity section, the liabilities section is one of the two major sources of a company’s funding.

For example, debt financing, that is borrowing capital from a lender in exchange for interest expense payments and the return of principal on the maturity date, is a liability since debt is a representation of future payments that will bring about a reduction in a company’s cash. However, in exchange for incurring the debt capital, the company obtains sufficient cash to purchase current assets such as inventory and to also make long-term investments in property, plant & equipment, or PP&E, which is capital expenditure.

As earlier stated, a company’s liabilities are reported on its balance sheet. In accordance with the accounting equation, the total amount of liabilities must be equal to the difference between the total amount of assets and the total amount of equity. The accounting equation is represented as;

Assets = Liabilities + Shareholders’ equity.

If the formula is rearranged, then the value of liabilities can be calculated as follows;

Liabilities = Assets – Shareholders’ equity

It is required for liabilities to be reported in accordance with the accepted accounting principles. The accounting standards that are most common are the International Financial Reporting Standards (IFRS), and many countries around the world adopt these standards; though many countries also use their own reporting standards such as the generally accepted accounting principles (GAAP) in the United States and the Australian Accounting Standards Board (AASB). Even though the recognition and reporting of the liabilities go according to different accounting standards, the main principles are close to the IFRS. Liabilities are listed on the balance sheet according to the time when the financial obligation is due.

Related: Common stock: Asset or Liability?

Liabilities examples
Liabilities examples

General liabilities examples

We can have a better understanding of what liabilities are all about when we look at the following instances;

A carpenter picks up a new kitchen cabinet from a supplier of cabinets. A cordial relationship exists between the supplier and the carpenter and with this, the former allowed the latter to buy on credit. The supplier then gives an invoice for the doors that he has to pay within 30 days. The amount that the carpenter owes for these doors is a liability for the carpenter, that is, he must meet this financial obligation within the stipulated period.

A freelance social media marketer is required by her state to collect sales tax on each invoice she sends to her clients. The money is in her bank account, however, it is still a liability because she is obligated to send that money to the state at the end of the month.

A dog walking business owner pays his ten dog walkers twice a week. It is Monday and he is required to pay $2,000 in wages by Thursday. The wages that he owes these employees count as a liability.

A copywriter, using her business credit card, buys a new laptop for $1,000. She plans to pay for that laptop in the near future probably in the next three months. This $1,000 that she owes to her credit card company is a liability.

An online rare bookseller decides to open up a brick-and-mortar store. He then takes out a mortgage of $500,000 on a small commercial space to open up the shop. This mortgage is a long-term liability as it is a debt that must be repaid.

See also: Capital Market Instruments, Examples, and Types

Types of liabilities

  1. Long-term or non-current liabilities
  2. Short-term or current liabilities
  3. Contingent liabilities

It is important to note that two types or classes of liabilities are recognized in the balance sheet, the long-term and the short-term liabilities. The third type which is contingent liability may either be a long-term or short-term liability.

1) Long-term liabilities

Long-term liabilities, also known as noncurrent liabilities, are financial obligations of a company that are due more than one year in the future. They are an important aspect of a company’s long-term financing. Companies take on long-term debt to acquire immediate capital that will help fund the purchase of capital assets or invest in new capital projects.

Long-term liabilities are crucial in the aspect determining a company’s long-term solvency. If companies are not able to repay their long-term liabilities as they become due, the company will be faced with a solvency crisis. We can say that long-term liabilities are useful when it comes to management analysis in the application of financial ratios.

The current portion of long-term debt is separated out because there is a need for it to be covered by more liquid assets such as cash. In essence, the long-term debt’s current portion is listed separately to provide a more accurate view of the company’s current liquidity as well as its ability to pay current liabilities as they become due. Various activities can cover the long-term debt, such as the primary net income of the company, future investment income, or cash from new debt agreements.

Solvency ratios such as debt ratios compare liabilities to assets. These ratios can be modified to compare the total assets to long-term liabilities only. This ratio is referred to as long-term debt to assets. Long-term debt compared to total shareholders’ equity provides insight that relates to the company’s financing structure and financial leverage. Also, long-term debts compared to current liabilities gives an insight into an organization’s debt structure.

Non-current liabilities are listed on the balance sheet after more current liabilities in a section that includes loans, debentures, deferred tax liabilities, and pension obligations. More examples will be given later. Long-term liabilities are not due within one year (12 months) or within the operating cycle of a company if it is longer than one year. A company’s operating cycle refers to the time it takes to convert its inventory to cash.

An exception to the two options above relates to current liabilities being refinanced into long-term liabilities. If there is an intent to refinance as well as evidence that refinancing has begun, the obligations will no longer be due within 12 months. Additionally, any liability that is coming due but has a corresponding long-term investment intended to be used as payment for the debt is treated as a long-term liability. It is required for the long-term investment to have sufficient funds to cover the debt.

Long-term liabilities examples

  1. Loan payable/Long-term notes payable
  2. Bonds payable
  3. Deferred tax liabilities
  4. Mortgage payable
  5. Capital leases
  6. debentures
  7. Pension obligations
Loan payable/long-term notes payable

Loan payable or long-term notes payable refer to debts that are due in more than one year. In other words, they are long-term liabilities indicating the money owed by a company to its financiers. These financiers could be banks and other financial institutions, as well as other sources of funds like family and friends. As earlier stated, they are long-term because they are payable for more than 12 months, though usually within five years.

Usually, companies borrow these funds to buy assets such as vehicles, equipment, and tools that can be used, amortized, and replaced within five years. There are some loans/notes payable that are secured. In other words, if the terms of payment are not met, the creditor has a claim on the borrower’s assets. If secured, the payment timeline could be longer.

These notes payable appear under the liabilities section of the balance sheet and can be separated into bank debt and other long-term notes payable. Payment details are usually available in the notes to the financial statements.

Bonds payable

Bonds payable is the remaining principal balance on bonds outstanding and it is due for payment in more than one year. It is the liability account containing the amount owed to bondholders by the issuer/company. It appears in the long-term liabilities section of the balance sheet because bonds mature in more than one year. If they mature within 12 months, then the line item will appear within the current liabilities section of the balance sheet instead.

The terms regarding bonds payable are contained in a bond indenture agreement which states the bonds’ face amount, the interest rate to be paid to bondholders, special terms of payments, and any covenants that have been imposed on the issuing entity.

An entity is more likely to incur bonds payable obligation when the long-term interest rates are low. With this, it can lock in a low cost of funds for a prolonged period of time. Conversely, this form of financing is less commonly used when there is a spike in interest rates. Typically, larger corporations and governments issue bonds.

Deferred tax liabilities

A deferred tax liability refers to a listing on a company’s balance sheet that records taxes owed but is not due to be paid until a future date. These liabilities extend to future tax years and in this case, they are considered long-term liabilities.

The liability is deferred as a result of the timing that exists between the time the tax was accrued and the time it is due to be paid. For example, it may be a reflection of a taxable transaction such as an installment sale that took place on a specific date but the taxes will not be due until a later date.

In simple terms, the deferred tax liability on a company’s balance sheet is a representation of a future tax payment that the company is obligated to make. It is calculated as the company’s anticipated tax rate multiplied by the difference between its taxable income and accounting earnings before taxes.

Deferred tax liability is the amount of taxes a company has underpaid which has to be made up in the future. This does not imply that the company has not fulfilled its tax obligations, it rather recognizes a payment that is yet to be due. Although it reduces the cash flow that is available for a company to spend, it is not a bad thing. The money has been designated for a particular purpose, that is paying taxes owed by the company. the company could run into trouble if it spends that money on anything else.

Mortgage payable

A mortgage payable refers to the liability that a property owner has to pay a loan that is secured by the property. From the perspective of the borrower, the mortgage is treated as a long-term liability. However, any portion of the debt that is payable within the next year will be classified as a short-term liability. the total amount due is the remaining unpaid principal on the loan.

Capital leases

A capital lease is a contract that entitles a renter to temporarily use an asset and has the economic characteristics of the ownership of assets for accounting purposes. It requires the renter to book assets and liabilities that have to do with the lease if the rental contract meets certain requirements. In essence, a capital lease can be considered an asset purchase while an operating lease is handled as a true lease under generally accepted accounting principles (GAAP). Although a capital lease is technically a form of a rental agreement, GAAP considers it a purchase of assets if certain criteria are met. Capital leases can impact the financial statements of companies thereby influencing interest expense, depreciation expense, assets, and liabilities.

Debentures

A debenture is a type of long-term business debt that does not have any collateral security. It is a funding option for companies that have solid finances that want to avoid issuing shares and diluting their equity. Debentures can be useful to companies that do not want to tie up assets or who lack collateral for a traditional loan.

It is a legal certificate stating the amount of money (principal) that the investor gave, the interest rate to be paid, and the schedule of payments. Investors usually receive their principal back at the end of the debenture’s term, that is at its maturity. This implies that the business typically only pays the interest, a percentage of the certificate’s face value, or loan amount during the loan period and then repays the full principal which is the loan amount at the maturity of the certificate.

Debentures can serve as a financing option for entrepreneurs that do not want to give up share value or for firms that are fast-growing and do not have a lot of assets. They are a form of debt capital and are recorded as debt on the issuing company’s balance sheet.

In other words, a debenture is a type of unsecured long-term business loan. For the fact that they are unsecured, it is required for the businesses issuing them to be creditworthy, have a good reputation, and show a positive track record of positive cash flow.

There are debentures that are convertible and the owner of such has the right to convert the loan into shares of the issuing business under the conditions that have been set out in the debenture certificate. A debenture can be partially convertible as well, meaning that part of its value can be converted into shares and cash.

Unlike a typical loan, the owner of the debenture, that is the person or entity lending the money can sell the debenture to another party thereby making it marketable security. There are corporate debentures that are traded on stock exchanges. Typically, a debenture owner is faced with less risk than a shareholder because interest payments on a debenture are generally made before share dividends payment.

Pension obligations

A pension obligation refers to the present value of retirement benefits that employees earn. Usually, an actuary determines the amount of this obligation based on a number of assumptions. These assumptions include estimated future pay raises, estimated employee mortality rates, estimated interest costs, estimated remaining employee service periods, amortization of prior service costs, and amortization of actuarial gains or losses.

The amount of this liability is then reduced to its present value to derive a company’s pension obligation. This amount is compared to the current funding of a plan to determine the additional funding that is needed. This examination is of great use in the aspect of determining a company’s future payout obligations. In essence, during employment, the company or employer builds up a liability for the amounts that it will subsequently pay to retired employees, this is the pension obligation.

2) Short-term liabilities Examples

Short-term liabilities, also known as current liabilities, refer to a company’s short-term financial obligations that are due within 12 months or within a normal operating cycle (cash conversion cycle). One of the current liabilities examples is money owed to suppliers in the form of accounts payable.

The management of companies should take a close watch on current liabilities in order to ensure that the company possesses enough liquidity from current assets to guarantee that the company will be able to meet the debts or obligations.

Current liabilities are used as short-term liquidity measures, this means that they are used in determining a company’s liquidity through liquidity ratios.

Sometimes, companies make use of an account called “other current liabilities” as a catch-all line item on their balance sheets to help include other liabilities due within a year that are not classified anywhere. Current liability accounts vary across industries or according to different government regulations.

Oftentimes, analysts and creditors make use of the current ratio which measures the ability of a company to pay its short-term financial debts or obligations. This ratio is calculated by dividing current assets by current liabilities, it shows how well a company manages its balance sheet to meet up with its short-term financial obligations and payables. It gives investors and analysts an overview of whether a company has enough current assets on its balance sheet to meet or pay off its current debt and other payables.

The quick ratio is another measure of a company’s liquidity. Its formula is similar to that of the current ratio but it subtracts the value of total inventory beforehand. The quick ratio tends to be a more conservative liquidity measure since it only includes the current assets that can quickly be converted to cash to pay off its current liabilities.

A number that is greater than one is ideal for both quick and current ratios since it indicates that there are more current assets to pay current short-term debts. However, if the figure is too high, it could mean that the company is not leveraging its assets as it otherwise could be.

Although current and quick ratios give an overview of how well a company converts its current assets to pay off its current liabilities, it is critical to compare the ratios to companies that are within the same industry. Analyzing current liabilities is of relevance to investors and creditors. For example, banks want to know this before extending credit whether a company is collecting or getting paid for its accounts receivables timely. This shows that early payment of a company’s payables is important as well. Both current and quick ratios are helpful in analyzing a company’s financial solvency as well as the management of its current liabilities.

When a company determines that it received an economic benefit that has to be paid within a year, it is required for it to immediately record a credit entry for a current liability. Depending on the received benefit’s nature, the company’s accountants may classify it as either an asset or expense which will receive a debit entry.

Current liabilities examples

  1. Accounts payable
  2. Interest payable
  3. Income taxes payable
  4. Bank account overdrafts
  5. Accrued expenses
  6. Short-term loans
  7. Sales tax
  8. Payroll taxes
  9. Taxes on investments
  10. Prepaid income
  11. Salaries and wages owing
  12. Insurance payable
  13. Dividends payable
  14. Current maturity of long-term debt
Accounts payable/bills payable

Accounts payable otherwise known as bills payable are the short-term obligations of a company owed to its creditors or suppliers that have not been paid. On the balance sheet, they appear as a current liability. In other words, the total accounts payable balance at a particular point in time will appear on its balance sheet under the current liabilities section.

In order to avoid default, accounts payable must be paid off within a given period. At the corporate level, accounts payable are short-term payments that are due to suppliers. This payable is essentially a short-term IOU from one business entity to another. The other party or entity will record that transaction as an increase to its accounts receivable in the same amount.

If accounts payable increase over time, it is an indication that the company is buying more goods and services on credit than it is paying cash. On the other hand, if a company’s accounts payable decreases, then it is an indication that the company is paying on its prior period obligations at a faster rate than it is purchasing new items on credit. It is critical for a company to manage its accounts payable as it is key in managing the cash flow of a business.

When making use of the indirect method to prepare the cash flow statement, the net increase or decrease in accounts/bills payable from the prior period appears in the top section, the cash flow from operating activities. For example, if management intends to increase cash reserves for a certain period, it can extend the time it takes for the business to pay all outstanding accounts in bills payable. However, it is required to weigh this flexibility to pay later against the ongoing relationships the company has with its vendors. Therefore, it is always a good business practice to pay bills on their due dates.

Interest payable

Interest payable refers to the amount of interest on a company’s debt owed to its lenders as of the date stipulated on the balance sheet. This amount can be a crucial aspect of financial statement analysis. If the amount of interest payable is higher than the normal amount, it is an indication that the business or company is defaulting on its debt obligations.

Interest payable can include both billed and accrued interest, though accrued interest may be reported in a separate accrued interest liability account on the balance sheet. Interest is considered to be payable regardless of the status of the underlying debt as either short-term or long-term debt. It has been stated that short-term debt is payable within one year while long-term debt is payable in more than one year.

It is important to note that the interest that will be incurred by a company in the future from its use of existing debt is not an expense yet. Because of this, it is reported in the interest payable account until the period the company incurs the expense. Until that time, the future liability may be noted in the disclosures that come with the financial statements.

Income taxes payable

Income tax payable is an example of tax liabilities, a liability that is incurred based on the reported level of profitability. In this context, this financial obligation to the applicable government has not been met. It could be the federal or state government within which the business entity or company resides. Once the income tax is paid by the organization, the liability is eliminated.

As an alternative to payment, it is possible to reduce the income tax liability through the application of offsetting tax credits, which the applicable government entity grants. Since tax credits typically expire after a time period, it is required for one to pay close attention to the ones that are available and are applicable to an income tax payable.

The amount of income tax payable is not necessarily solely on the basis of the accounting period that a business reports. There may be a number of adjustments that the government allows, which alters the accounting profit to result in a taxable profit, against which the income tax rate then becomes applicable. These adjustments can bring about timing differences between the profit recognition for accounting and the reporting of tax that in turn, can bring about differences in the amount of income tax payable (as it is calculated on a tax return) and the income tax expense reported in the income statement of a company.

Bank account overdrafts

A bank overdraft occurs when there are no sufficient funds in an account to cover a transaction or a withdrawal, but the bank still allows the transaction. It is essentially an extension of credit from the financial institution that is granted when the account gets to zero. The overdraft allows the holder of the account to continue withdrawing money even in cases whereby the account has no funds in it or has insufficient funds to cover the amount of withdrawal. Basically, an overdraft means the bank allows customers to borrow a set sum of money. Interest on loan exists and a fee typically exists per overdraft. The fee of an overdraft for many banks can run upward of $35.

To simply put it, with an overdraft account, a bank is covering payments made by a customer that would otherwise be rejected, or in the instance of actual physical checks, would bounce and be returned without the payment being successful.

Just as it is with any loan, interest is paid by the borrower on the outstanding balance of an overdraft loan. Usually, the interest on the loan is lower than the interest on credit cards thereby making the overdraft a better short-term option in an emergency case. In several cases, there are additional fees for making use of overdraft protection that reduce the amount available for one to cover his checks such as insufficient funds fees per check or withdrawal.

Accrued expenses

The term accrued expense refers to an expense recognized on the books before it is paid. It is recorded in the accounting period in which it was incurred. Since accrued expenses are a representation of a company’s obligation to make cash payments in the future, they are treated as current liabilities on a company’s balance sheet. An accrued expense is otherwise known as an accrued liability.

an accrued liability can be an estimate and may differ from the supplier’s invoice which will arrive at a later date. Going by the accrual method of accounting, expenses are recognized when they are incurred, not necessarily when they are paid.

Accrued liabilities example can be explained in this scenario; A company purchases supplies from a vendor but is yet to receive an invoice for the purchase. Other accrued liabilities examples are interest payment on loans, warranties on products and services received, and taxes that are being incurred or obtained but no invoices have been received for such as well as no payments have been made. Employee commissions, wages, and bonuses are accrued in the time they occur although the actual payment takes place in the following period.

Short-term loans

A short-term loan is a type of loan that one obtains in order to support a temporary personal or business capital need. It is a type of credit facility that involves the repayment of the principal amount and the interest by a stipulated due date which is usually within a year from the period the loan was obtained.

It is a valuable option, particularly for small businesses and startups that are yet to be eligible for a credit line from a bank. They are not only suitable for businesses but also for individuals who find themselves with a temporary sudden issue with cash flow.

Short-term loans are so called because of how quickly they need to be paid off. In most cases, they are required to be paid off within six months to a year and at most, eighteen months. Any longer loan term than this will be considered a medium-term or long-term loan.

Examples of short-term loans include merchant cash advances, lines of credit, payday loans, online or installment loans, and invoice financing.

Sales tax

A sales tax is another tax liability that is paid to a governing body for the sales of certain goods and services. Oftentimes, laws allow the seller to collect funds for the tax from the customer at the point of purchase.

In situations whereby it is the consumer that pays a tax on goods or services, it is usually referred to as a use tax. Most times, laws make provision for the exemption of certain goods or services from sales and use tax such as food, education, and medicines. A value-added tax (VAT) on goods and services is closely related to a sales tax. These tax liabilities are usually payable on a monthly or quarterly basis.

Payroll taxes

A payroll tax is a percentage that an employer withholds from an employee’s pay and then pays it to the government on behalf of the employee. This tax is mostly based on wages, salaries, and tips paid to employees. Federal payroll taxes are deducted directly from the earnings of the employee and paid to the IRS.

Taxes on investments

If an investor makes any profit from investments during an accounting period, he may be liable for tax payments. This is referred to as taxes on investments. The amount owed will be dependent on the type of investment, where one holds his investment, and the profit earned. Taxes on investments fall into two primary categories, income tax and capital gain tax.

Prepaid income

Prepaid income refers to funds received from a customer prior to the provision of goods and services. this concept is usually seen in businesses that require repayment for the manufacture of custom goods. Prepaid income is not used in other industries like retailing, where payment is always made at the time of sale or later. It is considered a liability because the seller has not yet delivered the goods or services to his customer. So on the seller’s balance sheet, it appears as a current liability. The liability is canceled and the funds are recorded as revenue as soon as the goods or services have been delivered.

Salaries and wages owing

Salaries and wages are liabilities to the employer when they are unpaid. The amount of salaries paid to employees in the company is quite large. In other words, the company comprises salaried personnel as is frequently the case in a professional services business such as a consulting firm.

It is possible for an employee to be terminated without his severance being paid.

A company may employ a number of salaried personnel but yet have no salaries and wages owing as of the end of the period. This is usually because no day exists at the end of the period for which employees worked for their salaries but have not been paid yet.

Insurance payable

Insurance liabilities are payables that are due to an insurance company from the company as well as any of its subsidiaries which may arise from time to time in its normal course of business. Every company that enters into an insurance policy will be faced with this liability. Also, there are some companies or individuals that are compelled by law to enter into certain insurance policies. With this, they are liable to pay insurance charges.

Dividends payable

An accrued dividend is a liability term accounting for dividends on common stock that have been declared but are yet unpaid to shareholders. They are treated in the books of account as a current liability from the declaration date and remain as such until the date of the dividend payment. Accrued dividends are also known as dividends payable. They are also synonymous with accumulated dividends, which make reference to dividends due to cumulative preferred stockholders.

When a company declares a dividend, the accrued dividend or dividend payable account is credited and the retained earnings account is debited in the amount of the dividend payment intended. No accounting rules mandating a time frame in which the accrued dividend entry is to be recorded are in place. Most companies usually book it a few weeks before the date f payment.

After the declaration of the dividend, it becomes the record-date shareholder’s property and it is considered different from the stock. This gives room for the shareholders to become the company’s creditors, as a result of their dividend payment, in case a merger or some other corporate actions take place.

Current maturities of long-term debt

In fixed-income investing, the current maturity refers to the time interval between the present day and the maturity date of the issued bond. It is an important metric in the valuation of that bond. Current maturity is the portion of long-term debt that will be due in the next 12 months. In corporate finance, the current maturity of a firm’s long-term debt includes those financial obligations that are due in less than a year. The current maturity reveals how long the bond has left until maturity.

Income taxes

An income tax payable is another type of tax liability that a company is obligated to meet. It comprises taxes that are due to the government within one year. This is a component that is necessary for calculating the deferred tax liability of an organization. Deferred tax liability in this case arises when reporting a difference between the income tax liability of a company and income tax expenses. The difference may be a result of the timing of when the actual income tax is due.

3) Contingent liabilities examples

Contingent liabilities are probable in nature, they are liabilities that may occur depending on a future event’s outcome. In other words, they are potential liabilities.

In essence, it is required for two conditions to be met before liability can be regarded as contingent. These conditions are the fact that the outcome is probable and that the liability amount can reasonably be estimated (on the basis of the remedies asked by the opposite party). If one of these conditions is not met or satisfied, then a company will not record a contingent liability on the balance sheet. A company should, however, disclose this item in a footnote of the financial statements.

It was earlier stated that long-term and current liabilities are the two basic types of liabilities that are recorded on the balance sheet. The contingent is the third type of liability that some businesses may record on their balance sheets.

One of the most common contingent liabilities examples is legal liabilities. Assuming a company is involved in litigation, the company may expect to lose the court case if the opposite party provides stronger evidence. This will certainly result in legal expenses.

Three scenarios exist for contingent liabilities; these are high probability of loss, medium probability of loss, and low probability of loss. A contingent liability should not be disclosed if the probability of its occurrence is remote.

The accounting rule for treating a contingent liability is quite liberal. There is no need for a company to record a liability unless the risk of incurring a loss is quite high. With this, it is important to revise disclosures that accompany a company’s financial statements to see if there are additional risks that are yet to be recognized.

Examples of contingent liabilities in accounting

  1. Lawsuit/legal liabilities
  2. Warranty
  3. Non-operating liabilities
  4. Product liabilities
Lawsuit/legal liabilities

Legal liability is a commitment that is imposed on a party due to a contract or civil action. This may be covered by insurance, usually under the liability insurance policy. A legal liability also means a responsibility that business owners have under the law for injuries or losses they inflict upon others. This judgment can bring about fines, penalties, or other payments.

Warranty

A warranty can also be treated as a contingent liability since uncertainty exists regarding the exact number of units that customers will return for repair or replacement. A warranty liability account records the amount of repair or replacement costs that it expects to incur from products that are already shipped or services that have already been provided.

The appropriate time to keep a record of warranty liabilities is in the same reporting period when the associated revenue is recognized. By so doing, a company ensures that all revenues and expenses related to the sales are recorded at the same time, that is the matching principle.

The number of warranty liabilities is based on the business’s historical experience in providing warranty repairs or replacements.

Nonoperating liabilities

A nonoperating liability is an amount that a business owes that has no relationship with the ongoing operations of the business. This liability may be contingent or off-balance sheet liability which may be dependent on the outcome of a future event.

Product liability

Product liability is the legal responsibility that a company/manufacturer has for creating defective products. This is similar to a warranty but they are not the same because this liability may arise if anyone suffers damage or injury as a result of the defect. In this case, the producer of the product will be held responsible for the damages, medical expenses, or pains and suffering endured.

Product liability can take the form of design defects, manufacturing defects, and faulty warnings. A design defect occurs when the products are poorly designed. A manufacturing defect occurs when the manufacturer makes a mistake in fulfilling how the product should be produced. A faulty warning is a situation where products are expected to come with directions and warning labels but the manufacturer fails to disclose any dangers or these dangers were not well communicated. Then this will pose a liability on part of the manufacturer.

See also: Accumulated Depreciation on Balance Sheet

Last Updated on November 8, 2023 by Nansel Nanzip Bongdap