Essential characteristics of a liability :
A liability is defined in the current Conceptual Framework as ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’. Important aspects of this definition represents characteristics of a liability:
- A legal debt constitutes a liability, but a liability is not restricted to being a legal debt. Its essential characteristic is the existence of a present obligation, being a duty or responsibility of the entity to act or perform in a certain way. A present obligation may arise as a legal obligation and also as an obligation imposed by custom or normal business practices (referred to as a constructive obligation).
For example, an entity may decide as a matter of normal business policy to rectify faults in its products even after the warranty period has expired. Hence, the amounts that are expected to be spent in respect of goods already sold are liabilities.
- A present obligation needs to be distinguished from a future commitment. A decision by management to buy an asset in the future does not give rise to a present obligation.
- A liability must result in the giving up of resources embodying economic benefits which requires settlement in the future. The entity has little discretion in avoiding this sacrifice. This settlement in the future may be required on demand at a specified date or on the occurrence of a specified event.
- A liability is that it must have resulted from a past event. For example, wages to be paid to staff for work they will do in the future is not a liability as there is no past event and no present obligation.
The IASB and FASB have proposed to change the definition of a liability by focusing on a liability as an enforceable “economic obligation” rather than an expected future sacrifice of economic benefits.
Furthermore, the reference to past events is to be replaced by a focus on the present. The essential attributes of an enforceable obligation include the involvement of a separate party and the existence of a mechanism that is capable of forcing an entity to take a specified course of action. A limited liability company also has obligations to internal and external stakeholders but those are limited in nature.