Liabilities

Definition:
A liability is the present obligation of an enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise embodying economic benefits. In other words liabilities arise from past transactions or events that will require the future payments of assets or performance of services. Examples : buying goods on credit, accepting advance payment from customer, taking a bank loan.

I am not a liability !
Example : A company may sign a three year contract with a supplier for purchase of copper for Rs.1,00,000 per year. This is commitment to pay for purchase to be made in the future. The company is not obliged to pay until the merchandise is purchased . Since there is no present obligation, no liability is recorded when the contract for purchase of goods is signed.

Classification Of Liabilities
Current Liabilities
Long-term Liabilities Secured Loans Unsecured Loans

Current Liabilities
Obligations that expected to be paid within one year of the Balance Sheet date or within the operating cycle of the business, whichever is longer. These liabilities are usually paid by using existing current assets or by creating other current liabilities. Examples: Creditors, Bills Payables, bank overdraft , unearned revenues and accrued expenses.

Long-term Liabilities
Liabilities that will not be due in the next year or in the operating cycle are classified as long-term liabilities. Examples: Debentures payable, long-term loans, lease rental payables and pension payables.

Secured Loans
Secured loans are those where the specific assets of the borrower are pledged, hypothecated or mortgaged as security. If the borrower defaults the creditor can sell the assets and use the proceeds to settle the dues.

Unsecured Loans
Are incurred based on the general credit standing of the borrower since they are only backed by the legal claim against the general assets of the borrower.

Current Liabilities
Definite Liabilities

Estimated liabilities

Definite Liability
Current Obligations that are determined precisely.

Bills Payable
When a business buys merchandise or equipment on credit or take loads, it issues bills payable to the seller or lender. Example: Suppose that Singhal Corporation borrowed Rs. 10,000 from Hindustan Finance by signing a bills payable.
May 1 Cash A/c Dr. 10000
10000

To Bills Payable

 When Singhal Corporation pays the bill on the maturity date july 30
July 30 Bills Payable A/c Dr 10000 300 10300

Interest ExpenseA/c Dr. To Cash Paid 90 day , 12% bill payable of Rs. 10000 with interest

Sales Tax Payable

A tax imposed by the government at the point of sale on retail goods and services. It is collected by the retailer and passed on to the state It is based on a percentage of the selling prices of the goods and services and set by the state.

Accounting Treatment
Madura enterprises sell goods Rs. 1000 plus 10% sales Tax.
Nov 19 Cash To Sales To Sales tax Payable To record sales and collection of sales tax 100 A/c Dr 1100 1000

Nov 19

Sales tax PayableA/c 100 Dr.

To cash To record the payment of sales tax

100

Value Added Tax

Meaning : VAT has replaced sales tax on most goods. The purpose of VAT is to eliminate the cascading effect of sales tax. When a dealer buys goods and pays VAT, he can claim credit for the amount paid from tax payable by him when he sells the goods . As a result each buyer pays tax on the increase in the value of the goods.

Illustration
Madhur company bought the goods on september 27 for Rs.800 plus VAT at 10%.
Sept 27 Purchases VAT Credit Receivable To Cash A/c Dr 800 80 880

To record purchase including VAT paid

At the time of sale

Nov 19 Cash
To Sales To Sales tax Payable To record sales and collection of sales tax 100

A/c

Dr

1100
1000

The entry to record the payment of TAX

Dec 4 Sales Tax Payable A/c Dr To VAT To Cash To record payment and of sales tax 100

80 20

Current Portions of Long-term Debt

A portion of long-term debt may be payable in the course of next 12 months. For example suppose that a loan of Rs. 100000 is to be paid in installments of Rs.10000 in the next 10 years. Consistent with the definition of current liabilities an enterprise must classify the installment of Rs. 10000 payable in the next year as long-term debt due within one year under current liabilities.

Interest Accrued But Not Due On Loans

Interest is due and payable on loans on the date specified in the agreement. The amount of interest accrued upto the end of accounting period is shown as the current liability. In contrast interest accrued and due should be included under either secured or unsecured loans.

Estimated Liabilities or Provisions

Are definite obligations for which the precise amount cannot be determined presently. The only accounting problem is to make a reasonable estimate of the amount of the liability and record it. Examples: income tax, product warranties and employee benefits.

Income Tax
A company is a separate entity and must file tax returns and pay tax on its income. The Central Govt. levise central corporate tax in accordance with the Income Tax Act 1961. The computation of large corporations is very complex because it must take into consideration not only the provisions of the act but also decisions of the courts and instructions issued by central board of direct taxes.

Contd
Besides, disputes with the tax authorities over the amount of tax payable involve timeconsuming legal procedures. The precise amount of income tax is seldom known when the financial statements are prepared. Since income tax is the expense of the year in which income is earned the liability should be estimated and recorded by the adjusting entry at the end of the year.

Illustration
Income tax expense is Rs. 36500. The following entry records the liability:
May 1 Income Tax Expense A/c Dr.
To Income Tax Payable To record estimated income tax expense

10000
10000

Product Warranties
A warranty or guarantee is given to the purchaser by a product manufacturer or provider of a service with the understanding that the manufacturer or provider will replace or repair a defective product or make good an ineffective service within a predetermined span of time. The cost of the warranty is an expense of the period in which the product is sold since the warranty helped the sale. The exact amount of warranty is not known at the time of sale and the warranty expense is estimated based on past experience.

Illustration
Assume that a company sells watches at an average price of Rs.1500 with one year warranty. Under warranty for a year the company will replace free of cost any defective part but the labor charges to be paid by the customer. During the year ended 31st March 2011, the company sells 2000 watches. Past experience shows that the 5% of the watches are defective and the cost of the warranty replacement is Rs.50 per unit.

The adjustment entry to estimated warranty expense and liability will be :

March 31 Product Warranty Expense A/c Dr. To estimated warranty liability 5000

5000

To record estimated product warranty and liability

When a watch is serviced under warranty bthe cost of the repair is charged to the estimated warranty account. Example: Assume that 13 watches are returned in April because of defects and the company carried out repairs at a cost of Rs.45 per watch. The transaction is recorded as follows:
April 30 Estimated warranty liability A/c Dr. To Cash To record replacement of parts under warranty 485

485

Dividends Payable
Are distributions of assets by the company. The BOD proposes a certain rate of dividends to the shareholders who may accept or reject the proposal. The proposed dividend becomes a liability when it is accepted by the shareholders. There is no need to show a liability when the proposal is made.

Contingent Liabilities
Is a possible obligation that arises from past events and the existence of which will be confirmed only by the occurrence or (b) a present obligation that arises from past events but is not recognized because (i)it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or (ii) a reliable estimate of the amount of the obligation cannot be made.

Contd
A contingent liability will be confirmed by the outcome of an uncertain event. Either it may result from a remote possibility or a reliable estimate of the liability that cannot be made. A contingent liability is iffy Once the uncertainty surrounding the outcome of the event is resolved the contingent liability will either become a full fledged liability or altogether eliminated. Example: Tax liability disputed, product liability suits and demands for increase in bonus or wages.

Accounting Treatment
It depends on the expected outcome of the contingency. If it is probable that the contingency will occur that is the probability is greater than .50 and the amount of the resulting loss can be reasonably estimated the contingent liability should be recorded in the accounts. However if the contingency is not possible though it may occur or the amount of contingent loss cannot be estimated , the contingency should be disclosed in the notes of the financial statements. A contingency which may be only remotely possible need not be disclosed .

Long-term Liabilities
Debentures, mortgages , leases and pensions.

Debentures
Debentures are creditor ship securities representing long-term indebtedness of a company. A debenture is an instrument executed by the company under its common seal acknowledging indebtedness to some person or persons to secure the sum advanced. It is, thus, a security issued by a company against the debt. Debentures, like shares, are equal parts of loan raised by a company. Like shares, they are issued to the public at part, at a premium or at a discount. Debenture-holders are creditors of the company. They have no voting rights but their claims rank prior to preference shareholders and equity shareholders. Their exact rights depend upon the nature of debentures they hold.

Contd
Its a written promise to pay a principal amount at a specified time as well as interest on the principal at a specified rate per period. A debenture certificate is issued to each lender as evidence of the companys obligation toe the debenture holder. The debenture trust deed also known as indenture is the legal document that states the rights and obligation of the debenture holders and the issuer. This deed contains a number of covenants for the protection of the lenders. The covenants deals with many matters including interest rate to be paid , maturity date and amount and further borrowings by the issuer. A company can sell directly to the public or the underwriter The issuer appoints a bank or a debenture trustee to represent large number of debenture holders The primary function is to ensure the issuer complies with the terms of the trust deed.

Secured and Unsecured Debentures

Secured or mortgaged debentures- debentures which are backed by specific assets to ensure its repayment. Most debentures issued in India are secured by mortgage . Pledge or hypothecation. Unsecured debentures, on the other hand, have no such charge on the assets of the company. The are issued by the general creditworthiness of the issuer.They are also known as simple debentures.

Registered and Bearer Debentures

Registered debentures are registered with the company. Name, address and particulars of holdings of every debenture holders are recorded on the debenture certificate and in the books of the company. At the time of transfer, a regular transfer deed duly stamped and properly executed is required. Interest is paid only to the registered debenture holders. Bearers debentures on the other hand, are transferred by more delivery without any notice to the company. Company keeps no record for such debentures. Debentures-coupons are attached with the debenturescertificate and interest can be claimed by the couponholder.

Redeemable and Irredeemable Debentures

Redeemable debentures are those which can be redeemed or paid back at the end of a specified period mentioned on the debentures or within a specified period at the option of the company by giving notice to the debenture holders or by installments as per terms of issue. Irredeemable debentures are those which are repayable at any time by the company during its existence. No date of redemption is specified. the debenture holders cannot claim their redemption. However, they are due for redemption if the company fails to pay interest on such debentures or on winding up of the company. They are also called perpetual debentures

Convertible and Non-convertible Debentures

Convertible debentures are those which can be converted by the holders of such debentures into equity shares or preference shares. A convertible debenture has a stipulated conversion rate of some number of shares for each debenture.

Zero-coupon Bonds
A debt security that doesn't pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value. Also known as an "accrual bond".

Debenture Ratings
Investment Quality Highest Safety High Safety Adequate Safety Moderate Safety Inadequate Safety High Risk Substantial Risk In Default CRISIL AAA AA A BBB BB B C D ICRA LAAA LAA LA LBBB LBB LB LC LD CARE CARE AAA CARE AA CARE A CARE BBB CARE BB CARE B CARE C CARE D

Accounting For debentures

All debentures have a face value or par value