This article will discuss the definition of liability, what it means in business, and how it works in accounting.
In accounting, liabilities are the financial obligations of a company. Liabilities can be in the form of loans owed to banks, money owed to supplies, wages to staff, or any other form of debt owed by a company. Accountants record this information in what is known as the balance sheet. Liabilities are essential for a company because they help a business grow and it is vital to keep a record of your company’s liabilities to know what your company’s net worth is.
Liabilities are not just for businesses. Everyone has some form of liability, such as credit cards, personal loans, and mortgages. It’s essential to learn more about them.
What is a Liability?
As stated before, a liability is something that is owed; however, it should be known that liability and expenses are not the same things. A more in-depth definition of liabilities in business is that they, “are something that needs to be paid off using your assets.”
In the role of finances, liabilities are considered legal obligations that a business or individual has to pay back in cash or other financial assets. These contractual obligations can be, bank loans, finance lease liabilities, trade, and other payables, and other interest-bearing financial liabilities.
A good example of a liability in a business would be accounts payable. This is something that is considered a current liability because it has to be paid within a business’s fiscal year. It is a short-term legal obligation. Accounts payable is a company’s short-term debt obligation to its creditors and suppliers. It will be under the current liabilities on a company’s balance sheet and it represents the total amount due to suppliers or vendors for invoices that have yet to be paid. A typical time frame that a vendor will give a company to pay something is between 15 to 45 days. The company would receive the supplies and can pay for them at a later date.
How to define Liability in Finance?
A common definition for financial liabilities is, “any future sacrifices of economic benefits that an entity is required to make as a result of its past transactions or any other activity in the past. The future sacrifices to be made by the entity can be in the form of any money or service owned to the other party.”
With this definition as a framework, we see that liabilities are usually legally enforceable as a result of an agreement signed between two entities. Liabilities can also be based on equitable obligations like a duty based on ethical or moral reasoning.
Assets and liabilities help accountants calculate the financial outlook of a company. These financial aspects of a company help accountants consider the ways a company is generating money, as well as what items take away from a business’s profits.
Basically, an asset is something that a business owner owns, while a liability is something that a business owner owes. It can be difficult to define what a liability is for someone first starting out in accounting because liability can turn into an asset.
What are the 4 Key Factors for a Liability?
There are 4 key factors in defining a liability. The first is that there is a contractual obligation. Either this contractual obligation requires delivery of cash or another financial asset to another entity, or there is an exchange of financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity. A contract may be settled in the entity’s own equity instruments and is a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments. Or a contract is settled in the entity’s own instruments and is a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.
How do Liabilities work in Finance?
There are different ways that liabilities can work in finance. Let’s look at a few examples.
For a bank, liabilities are either the deposits of customers or money that banks borrow from other sources. These are used to fund assets that can earn revenue. A bank uses liabilities to buy assets, which earns its income. By using liabilities, such as deposits or borrowings, to finance assets, such as loans to individuals or businesses, or to buy interest-earning securities, the owners of the bank can leverage their bank capital to earn much more than would otherwise be possible using only the bank’s capital.
An employee can have liabilities from their place of work in the form of income withheld from their paycheck to cover things like payroll tax, social security tax, Medicare tax, and various other withholding. The employer withholds those taxes that are paid by employees.
Families and households have liabilities as well. For example, liabilities for a family may include taxes due, bills that must be paid, rent or mortgage payments, loan interest and principal due, and so on. If a family has to be pre-paid for performing work or service, the work owed may be a liability as well.
Why do Accountants need to know the Liability Definition?
Accountants should be aware of the liability definition in order to perform the function of their work and duties for their employer. Knowing how to identify what is a liability for a company allows an accountant to better understand how that company is performing financially.
What are the Types of Liabilities?
There are three types of liabilities; current liabilities, non-current liabilities, and contingent liabilities. We will look at all three.
1. Current Liability
Current liabilities are liabilities that are due within a year. These occur as part of regular business operations.
What are the types of Current Liabilities?
- Accounts payable: unpaid bills to the company’s vendors. These are typically the largest current liability for most businesses.
- Interest payable: these are interest expenses that have already occurred but have not yet been paid.
- Income taxes payable: income tax amount owed by a company to the government. These are normally payable within one year.
- Bank account overdrafts: these are like short-term loans provided by a bank when the payment is processed with insufficient funds.
- Accrued expenses: these are expenses that have been incurred but no supporting documentation has been received or issued.
- Short-term loans: loans with a maturity of one year or less.
Why are Current Liabilities more important for Accounting?
It’s important for accounting to know about the current liabilities of a company because it shows the financial well-being of that company. For example, a bank would like to know about a company’s current liabilities before extending credit because it shows whether a company is collecting or getting paid for the accounts receivables in a timely manner.
2. Non-Current Liability
Non-current liabilities also known as long-term liabilities are liabilities that are due after more than one year. These exclude the amounts that are due in the short term, such as interest payable.
What are the types of Non-current Liabilities?
- Bonds payable: these are the number of outstanding bonds with a maturity of over one year issued by a company. On a balance sheet, the bonds payable account indicates the face value of the company’s outstanding bonds.
- Notes payable: the number of promissory notes with a maturity of over one year issued by a company. The notes payable account on a balance sheet indicates the face value of the promissory notes.
- Deferred tax liabilities: this is the difference between the recognized tax amount and the actual tax amount paid to the authorities. It means the company underpays the taxes in the current period and will overpay the taxes at some point in the future.
- Long-term debt: if a company has a long-term debt, it records the face value of the borrowed principal amount as a non-current liability on the balance sheet.
- Capital lease: capital leases are recognized as a liability when a company enters into a long-term rental agreement for the equipment. The capital lease amount is the present value of the rental’s obligation.
Why are non-current Liabilities more important for Accounting?
Non-current liabilities are important in accounting because it shows if a company is leveraging its resources in order to meet account payables. It gives a fair idea about a company’s cash flow stability and use of leverage.
3. Contingent Liability
Contingent liabilities are probable liabilities that are depending on the outcome of a future event. A contingent liability will happen only if the outcome is probable and the liability amount can be reasonably estimated. If only one of these things happens, a company does not need to report a contingent liability on the balance sheet. A common example of contingent liability is legal liabilities.
Are current liabilities debt?
Current liabilities and debts are often considered the same thing, however, there is little difference between the two. Some debts can be classified as liabilities but generally, they are referred to as borrowed money, whereas liabilities are referred to as financial obligations and may not necessarily be borrowed money.
How to understand whether something is a liability or not?
Total liabilities are a summation of all the current liabilities of the company. This includes notes payable, accounts payable, accrued expenses, unearned revenue, the current portion of long-term debt, and other short-term debt.
What is the liability determination formula?
A current liabilities formula can be expressed as,
Current liabilities formula= Notes payable + Accounts payable + Accrued expenses + Unearned revenue + Current portion of long term debt + other short term debt.
Why is the liability formula related to equity and asset?
Liability is related to equity and assets in the balance sheet equation and is set up as follows:
Assets= Liabilities + Equity
It shows how an asset is earned through liabilities or equity. The difference between liabilities and equity is that liabilities it is required by law to be paid back, whereas equity is discretionary. The cost of liabilities is deducted in the income statement, where distributions to owners are not treated as an expense.
What are the examples of liabilities?
What are some examples of liabilities?
1. Liability Examples for Families and Households
An example of liability for families and households would be a mortgage to cover the cost of housing.
2. Liability Examples for Business People
An example of liability for a business person would be a car loan or student loan if the person has taken out these loans.
3. Liability Examples for Employees
An example of liability for employees would be the income tax and interest that is unpaid.
4. Liability Examples for Investors
Investors have limited liability in a company which is a type of legal structure where a corporate loss will not exceed the amount invested.
What is the difference between an Asset and a Liability?
The main difference between an asset and a liability is that assets are items possessed by a business that will provide it benefits in the future and liabilities are items that are obligations to a business. Assets belong to the company where liabilities must be paid back.
What is the difference between a Liability and an Expense?
Liabilities are debts owed to third parties and expenses are the daily costs of running a business such as paying an electric bill to keep the power on.
What is the difference between Liability and Debt?
Current liabilities and debts are often considered the same thing, however, there is little difference between the two. Some debts can be classified as liabilities but generally, they are referred to as borrowed money whereas liabilities are referred to as financial obligations and may not necessarily be borrowed money.