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3.2. Liabilities: definition, classification, valuation

3.2.1. Definition

Liabilities are entity's obligations to transfer future economic benefits to third parties. They comprise: all debentures, borrowings from lenders, received bills and unpaid invoices, which are actual obligations; but also, accruals, which are obligations not yet substantiated by third parties' invoices or bills; and provisions for future expenses, which are not yet obligations, but will be in the future for facts that have happened in the past.

A few examples of the above mentioned liabilities follow. Debentures are mostly made of bonds, also called own debt instruments. Borrowings are short and long term loans, mortgages and overdrafts. Bills and invoices are documents received from providers of services and suppliers of goods who were not paid as yet when the accounts were closed. Accruals are obligations for services or goods that have been received, but whose bills and invoices have not been produced or received yet, e.g. rent, workforce, consultancies, raw materials. Provisions for future expenses are undefined commitments that the entity is certain or likely to have to honour in the future and which will, normally, be valued more exactly in the future, e.g. the costs of a legal case that is likely to be lost, the costs of decommissioning a field when the on-going extraction of minerals will reach an end.

3.2.2. Classification

Liabilities are classified according to when they are likely to fall due, i.e. within a year or in more than a year, as current and long term liabilities respectively. You will find provisions under either of the two categories according to when they are expected to become real.

Often you will find that the same long term obligation has also a short term leg, as it is the case of mortgages, for the principal components falling due within a year, debentures, for the bonds reaching their maturity within a year, etc.

3.2.3. Valuation

Liabilities are valued according to the expected value of the economic benefits that the entity will have to transfer to third parties, in order to settle the underlying obligations.

This means that the value you see in the balance sheet for each item of liability or provision represents a prudent valuation of how much the entity is likely to have to pay when the obligation will fall due, this being the result of a statistical calculation weighting the probabilities of possible outcomes of series of events or simply an estimate of the likely payment that the entity might be required to make. An example of the first is a provision for the cost of replacement or repair of faulty products covered by guarantee, whereby the entity can estimate the expected number of products that will be returned under the terms of the guarantee and hence calculate the cost of replace or repair them. An example of the second is a provision for a case in court, whereby it is known that the entity will succumb and an estimate is made of the most likely (and prudent) amount that will have to be paid. More common examples, though, are the liabilities towards suppliers and providers, which are reported at their nominal value, unless it is likely that only part of the total amount will have to be eventually paid.

Another typical liability item you will come across is deferred taxation. This occurs when the entity had been previously allowed to postpone the payment of its taxes, which created a liability to be paid in future years. Once again, this liability is likely to have a short term leg that reflects the amounts that are falling due in the next year.

You might also come across the liability component of a hybrid financial instrument. This is the case of your chosen entity having issued, for example, convertible bonds.14 In compliance with IAS 39, these instruments are reported splitting the debt component, as if the bond was an ordinary one, and the equity component, which is the embedded 'call option', i.e. the option to buy a share at a fixed price in the future. See appendix B for an example of this calculation.

For any other liability that you find in the balance sheet of your chosen entity, it is advisable to read the respective notes to the accounts, for explanations.

 
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