Chapter 6 discusses the accounting principles surrounding liabilities and equity, defining liabilities as financial obligations of an enterprise that require future sacrifice of assets. It covers the valuation of liabilities, distinguishing between current and contingent liabilities, and emphasizes the inconsistencies in current liability classifications which may mislead creditors. The chapter also explains various theories of equity, including entity, residual equity, proprietary, fund, and enterprise theories, which provide different perspectives on the relationship between a business, its owners, and creditors.

1. CHAPTER 6
Liabilities and Equity

2. Accounting to Institute of Chartered Accounting of India,
liability is “the financial obligation of an enterprise other
than owners’ funds.”
Liabilities possess the following characteristics:
1. Required future sacrifice of assets
2. Liabilities and proceeds
3. Obligation of a particular enterprise
4. Occurrence of a past transaction or event
5. Capital and dividend
6. Discontinuance of liability

3. Valuation of liabilities
The Valuation of liabilities is part of the process of measuring both
capital and income, and is important to such problems as capital
maintenance and the ascertainment of a firm’s financial position.
According to Borton, “the requirements for an accurate measure of
the financial position and financial structure should determine the
basis for liability valuation. Their valuation should be consistent with
the valuation of assets and expenses.” The need for consistency arises
from the objectives of liability valuation, which are similar to those to
asset valuation. Probably the most important of these objectives is the
desire to record expenses and financial losses in the process of
measuring income. However, the valuation of liabilities should also
assist investors and creditors in understanding the financial position.

4. Valuation of liabilities
Liabilities may be valued (i) at their discounted net
values in accordance with the manner of valuing
assets in economics; (ii) in accordance with accounting
conventions, they may be recorded at their historic
value, that is, the valuation attached to the contractual
basis by which they were created. There is no
difference between the two methods of valuation as
regards liabilities which are payable immediately, and
it is only as the maturity date of liabilities lengthens
that the difference appears.

5. Contingent Liabilities
A contingent liability is not a legal of effective liability; rather it is a
potential future liability. The amount of a c contingent liability may
be known or estimated. Contingent liabilities are those which will
arise in the future only on the occurrence of a specified event.
Although they are based on past contractual obligations, they are
conditional rather than certain liabilities. Thus, guarantee given by
the firm are contingent liabilities rather than current liabilities. If a
holding company has guaranteed the overdraft of one of its
subsidiary companies, the guarantee is payable only in the event
of the subsidiary company being unable to repay the overdraft.
Contingent liabilities are not formally recorded in the accounts
system, but appears as footnotes to the balance sheet.

6. Current Liabilities
“The term current liabilities is used principally to designate
obligations whose liquidation is reasonably expected to
require the use of existing resources properly classifiable
tend to be fairly permanent in the aggregate, but they
differ from long term liabilities in several ways. The main
distinctive features are: (1) they require frequent attention
regarding the refinancing of specific liabilities; (2) they
provide frequent opportunities to shift from one source of
funds to another; and (3) they permit management to vary
continually the total funds from short term sources

7. Classification of Current Liabilities
1. Accounts payable
2. Bills (Notes) Payable
3. Interest Payable
4. Wages and Salary Payable
5. Current Portion of Long-term Debt
6. Advances from Customers

8. Current and Non-Current Distinctions
The conventional definitions of current assets and current
liabilities are assumed to provide some information to financial
statements users, but they are far from adequate in meeting the
desired objectives. These inadequacies can be summarized as
follows:
1. One of the main objectives of the classification is to present
information useful to creditors. However, it is far from adequate
in serving this purpose. Creditors are primarily interested in the
ability of the firm to meet its debts as they mature. This ability
depends primarily on the outcome of projected operations; the
pairing of current liabilities with current assets assumes that the
latter will be available for payment of the former

9. Current and Non-Current Distinctions
2. Creditors are also interested in the solvency of the firm
— the probability of obtaining repayment in case the firm
is liquidated. It is contended that special statements
should be cash in liquidation and the special restrictions
regarding the use of particular assets or resources of cash.
In the conventional balance sheet, the pairing of current
assets with current liabilities leads to the false assumption
that, in liquidation, the short term creditors have
necessarily some priority over the current assets and that
only the excess is available to long term creditors.

10. Current and Non-Current Distinctions
3. As a device for describing the operations of the firm,
the classification is also defective. Such assets as
interest receivable do not arise from the some type of
operations as accounts receivable and inventories, but
they are all grouped together as current assets.
Among the current liabilities, dividends payable does
not arise from the same type of operations as
accounts payable, and from an operational point of
view, the current portion of long term debt is not
dissimilar to the remainder of the long term debt.

11. Current and Non-Current Distinctions
4. The current assets and current liability
classifications do not help in description of the
accounting process or in the description of
valuation procedures.

12. Theories of Equity
The different concepts (theories) of equity are as
follows:
1. Entity Theory
2. Residual Equity Theory
3. Proprietary Theory
4. Fund Theory
n5. Enterprise Theory

13. Entity Theory
In entity theory, the entity (business enterprises) is
viewed as having separate and distinct existence
from those who provided capital to it. Simply stated,
the business unit rather than the proprietor is the
centre of accounting interest. It owns the resources
of the enterprises and is liable to both, the claims of
the owners and the claims of the creditors.
Accordingly, the accounting equation is: Asset =
Equities or Assets = Liabilities + Shareholders’ Equity

14. 2. Residual Equity Theory
The residual equity theory is concept somewhere
between the proprietary theory and the entity theory.
In this view, the equation becomes: Assets—Specific
equities = Residual equity. The specific equities include
the claims of creditors and the equities of preferred
shareholders. However, in certain cases where losses
have been large or in bankruptcy proceedings, the
equity of the common shareholders may disappear
and the preferred or the bondholders may become the
residual equity holders

15. 3. Proprietary Theory
Under the proprietary theory, the entity is the agent,
representative, or arrangement through which the
individual entrepreneurs or shareholders operate. In this
theory, the viewpoint of the owners group is the centre of
interest and it is reflected in the way that accounting
records are kept and the financial statements are
prepared. The primary objective of the proprietary theory
is the determination and analysis of the proprietor’s net
worth. Accordingly, the accounting equation is viewed as:
Assets – Liabilities = Proprietor’s Equity

16. 4. Fund Theory
The fund theory emphasizes neither the
proprietor nor the entity but a group of assets
and related obligations and restrictions
governing the use of the assets called a “fund”.
Thus, the fund theory views the business unit as
consisting of economic resources (funds) and
related obligations and restrictions in the use of
these resources. The accounting equation is
viewed as: Assets = Restriction of Assets

17. 5. Enterprise Theory
The enterprise theory of the firm is a broader concept than the
entity theory, but less well defined in its scope and application.
In the entity theory the firm is considered to be a separate
economic unit operated primarily for the benefit of the equity
holders, whereas in the enterprise theory the company is a
social institution operated for the benefit of many interested
groups. In the broadest from these groups include, in addition to
the shareholders and creditors, the employees, customers, the
government as a taxing authority and as a regulatory agency, and
the general public. Thus the broad form of the enterprise theory
may be thought of as a social theory of accounting.