Liabilities are future obligations to others that have three essential characteristics. Firstly, a liability can be settled in the future by transferring or using cash or other assets, by providing services, or giving up other economic benefits. A future obligation that doesn't require giving up some economic benefit is not considered a liability. Secondly, the date that the obligation must be settled must be previously determined, or must be based on some specific event occuring, or can be on demand. However, the entity itself should have little discretion in avoiding the obligation. Thirdly, the transaction or other even that creates the liability must have already occured for the liability to be recognized.
Distinguishing Between Financial and Non-Financial Liabilities
In addition to our definition for liabilities, we also recognize a distinction between financial liabilities and those that are not financial in nature. According to the FASB master glossary, a financial liability is a contract that imposes on one entity an obligation to do either of the following: (a) deliver cash or another financial instrument to another entity or (b) exchange other financial instruments on potential unfavourable terms with another entity. It is important to recognize that this definition requires the liability to be based on a contract. Therefore, obligations that arise as a result of legislation, such as income taxes payable, are not considered financial liabilities. The distinction is important because financial liabilities may be required to be measured at fair value as opposed to historical cost.
Most current liabilities are financial in nature expect for those where the obligation will be met by the delivery of goods or services. For example, deferred revenue, commitments, gaurantees and warranties are often non-financial in nature. Long-term liabilities that are non-financial in nature may include asset retirement obligations, environmental obligations, exit or disposal cost obligations and loss contingencies.
Distinguishing Between Liabilities and Equity
One of the more complicated aspects of accounting for liabilities is the ability to determine whether an obligation is a liability or an ownership claim. For example, while perferred shares are reported as part of shareholders' equity we know that preferred shares, in fact, have many characteristics of debt. GAAP looks at distinguishing freestanding financial instruments which have characteristics of both debt and equity in.1
1. FASB ASC 480-10
Current liabilities mean liabilities that will become payable within a year or within the normal operating cycle (if this is longer than a year). As a result, we normal expect current liabilities to be settled using existing current assets.
Long-term liabilities mean liabilities that will become payable beyond one year or beyond the normal operating cycle (if this is longer than a year).
Future obligations such as warranties, guarantees, and customer loyalty programs are probably and can be estimated. As a result, an expense and correlated liability should be recognized today.
A contingency is an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an entity that will ultimately be resolved when one or more future events occur or fail to occur.
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