Introduction to Liabilities in Accounting
In financial accounting, a liability is an obligation arising from past transactions or past events. The settlement of such transactions may result in the transfer or use of assets, provision of services or benefits in the future.
A liability is defined as:
- Any type of borrowing for improving a business or personal income payable later.
- A duty or responsibility in-forced by law to another entity.
- A duty to other entity that involves settlement by transfer or use of assets, provision of services, or other transactions at a specified future date, on certain contracts, or on demand.
- A transaction or event that has occurred currently and obligates the entity.
Types of Liabilities in accounting
Liabilities are classified in different types based on their due duration and characteristics:-
1. Current Liabilities
These are short-term liabilities that are due and payable within one year generally by current assets. If a firm has operating cycles that last longer than one year, current liabilities are those liabilities which must be paid during the cycle.
Examples of Current Liabilities
- accounts payable,
- commercial paper payable,
- trade notes payable,
- short-term notes payable,
- operating costs include salaries payable, wages payable, interest payable, income tax payable
- the current balance of long-term debt due in a year.
- Callable long term debt like bonds
2. Long-term Liabilities
These are long-term liabilities that are due in over a year’s time. They are an important source of a company’s long-term financing.
Examples of Long-term Liabilities
- Long-term bonds payable
- Long-term notes payable
- Deferred tax liabilities
- Pension obligations
- Mortgage payable
- Capital Lease
3. Contingent Liabilities
These are liabilities that occur depending on the outcome of future events. So, basically, these are potential liabilities. A contingent liability is recorded only if it is probable and the associated amount can be estimated. They are typically recorded as notes in the company’s financial statement.
Examples of Contingent Liabilities
- Long-term product warranties,
- Penalties or fees in the course of business,
- Lawsuit Payable
Formula of Liabilities in Accounting
The relationship between the financial activities of a business is established by the Accounting Equation. It illustrates the relationship between a company’s assets, liabilities, and shareholder or owner equity.
The equation and what it means
Liabilities = Assets – Owner Equity
It is a simplified representation of how the financial side of business functions. Liabilities are the difference in the total assets of the organization and its owner’s equity.
Examples of Liability in Accounting
If a business wishes to purchase computer equipment worth £300, the purchase can be made in many possible ways.
If liability is used, the £300 can be paid off using assets or by new liability like a bank loan. This £300 will show as a liability in a financial statement.
Suppose a company that is in printing T-shirts need to buy equipment. They purchase $5,000 of the equipment on credit. In this way, they gain liability and an asset. Assets and liabilities increase by $5,000, the accounting equation is like:
$5,000 Assets = $5,000 Liabilities + Equity
where “equity” represents total stakeholder’s equity of the company.
Suppose company XYZ wishes to purchase a $500 machine with $250 in cash. It owes the manufacturer the remaining amount. Effect on the transaction would be
Equipment (+$500), and
Accounts Payable (+$250),
Advantages of Liabilities in Accounting
- A company’s liabilities are critical factors in any industry in which it is involved to assess the viability of any company.
- Economists, creditors, investors, etc all regard a business entity’s current liabilities as an important indicator of its fiscal health.
- One aspect of liabilities are associated with working capital. Working capital refers to the dollar difference between total current liabilities and total current assets.
- Long-term liabilities show long term solvency of the organization i.e its ability to pay off his long term debt.
- A small business owner must not eliminate all liabilities. It can be one of the most important tools for building a small business thus increases the value of the company. Liability can be used for purchasing necessary equipment or buying computer systems.
- Some liabilities have low-interest rates or have no interest rates associated with them. Some of a company’s accounts payable may allow payment in 30 days, so, it is better to have the liability and to keep cash in the bank until those credits become due.
- Liabilities help us to upgrade our living standards. Houses of many middle-class people are purchased with a down payment and mortgage loan. This mortgage loan liability is a good thing.
Disadvantages of Liabilities in Accounting
- Repayment: The sole obligation to the lender is to make payments, even if the business fails.
- High rates: Some liability have a high-interest rate. Some macroeconomic conditions, history with the banks, business credit rating and personal credit history may be responsible for such high rates.
- Impacts on your credit rating: A practice called “levering up” is bringing on debt when the firm needs money, such loan gets noted on credit report and affects credit rating.
- Cash and collateral: Business has to generate sufficient cash flow by the time repayment of the loan is scheduled to begin. In most cases, collateral is taken to protect the lender in the event of defaulter of payment.
- Financial Crisis: Too much dependency on liability can be harmful to the financials of the organization. Even, they can cause financial hardships.
- Fundamental investors prefer companies with lesser liabilities as compared to assets. Usually, companies that owe more money than they bring in business are in trouble situations and are not considered by investors. So, excess liabilities can be harmful in this sense also.
We can conclude that the liabilities’ position is a clear indicator of the financial health of any organization. Although assets are tangible, liabilities are also considered equally important as long-term debts and other types of liabilities are supposed to be settled before or on the date of a contract so that the organization can book profit, or else the organization may face bankruptcy for not paying its liabilities.
Liability gives important information helpful in analyzing the liquidity and solvency of the organization. It also includes the ability of the organization to repay loans, long-term debt, and interests.
This has been a guide to the Liabilities in Accounting. Here we also discuss the formula, types with the example, advantage, and disadvantages. You may also have a look at the following articles to learn more –