Liabilities: What are liabilities in accounting?

Liabilities: What are liabilities in accounting?

A balance sheet is a statement showing the assets and liabilities of a company over a period. Assets are what the business own while liabilities are what the business owe.

Previously, we explained the meaning of assets and types of assets, this article focuses on liabilities.

A liability is a debt a company owe to outsiders that requires the entity to give up an economic benefit (cash, assets, etc.) to settle debts or past transactions.

It's an amount a company owe to a supplier, bank, lender, or other goods provider, services, or loans. They are credited in the double entry bookkeeping method of managing accounts.

To settle a liability, a business must sell an economic benefit. An economic benefit can include cash, other company assets, or fulfill a service.

Where can we find Liabilities?

They are found in the balance sheet, opposite the asset section. This is because accounting records assets on the debit side, while liabilities are recorded on the credit side.

Types of Liabilities

There are two types of Liabilities;
1. Current Liabilities
2. Long-term Liabilities

Current Liabilities

They include all liabilities to be paid within one year. The ease with which a company can manage to settle its current liabilities are determined using the ‘current ratio’, which divides the company’s current assets by its liabilities (a high ratio is preferable).

Examples of current liabilities:
  1. Accounts payable
  2. Interest payable
  3. Income taxes payable
  4. Bills payable
  5. Bank account overdraft
  6. Accrued expenses
  7. Short-term loans
Long-term Liabilities

They are liabilities that are not due for payment within a year. 

Examples of non-current liabilities:
  1. Bonds payable
  2. Long-term notes payable
  3. Deferred tax liabilities
  4. Mortgage payable
  5. Capital leases
  6. Loans
  7. Pension payments
There is a type of liabilities called Contingent liabilities. They are liabilities that may or may not arise, depending on a certain event. For instance, if company ABC is facing a lawsuit of $100,000, the company would incur a liability if the lawsuit is successful.

However, if the lawsuit is not successful, then there is no liability. In accounting standards, a contingent liability is only recorded if the liability is probable (more than 50% likely to happen). The amount to pay for of the liability can be reasonably estimated.

Examples of contingent liabilities:
  1. Lawsuits
  2. Product warranties
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The Fundamental Accounting Equation

Liabilities are important part of the Fundamental Accounting Equation on which all accounting/bookkeeping is based:

Assets = Liabilities + Owner's Equity

Example 1: 
The balance sheet of Lagbaja Plc as at 31st December, 1999 has these information;

Assets = N20000
Capital = N5000
Liabilities = ?
Calculate the Liability.

Since Liabilities = Assets - Owner's Equity
Therefore, N20000 - N5000 = N15000
Liability = N15000

Example 2:
The Balance sheet of Johnson enterprises are as follows;
Land and Building        1000
Motor Van.                      1200
Creditors.                         500
Debtors.                           1000
Account payables.         1300
Account receivables.     1500
Cash.                                  500
Furnitures.                       800
Loans.                               1000
Capital.                             2000

You're required to calculate the Liability of Johnson Enterprises.

From the question above, the Liabilities are creditors, account payables, loans. Here we will add them up to arrive at the total.

Total Liabilities = $500 + $1300 + $1000 = $2800.

Recognizing Liabilities

There are rules for the proper recognition of liabilities that differ among accounting standards in different countries around the world. Liabilities directly represent any creditor claims on the assets of the business.

When recognised, liabilities can either be short-term or long-term. The general time frame that separates these two distinctions is one year, but are subject to change depending on the business.

Importance Of Liabilities To Small Business

Liabilities isn’t necessarily bad. Some loans are collected to buy new assets, like tools or vehicles that help a small business operate and grow.

But too much liability can hurt the finance of a small business. Owners should track their debt-to-equity ratio and debt-to-asset ratios. This simply means that, a business should have enough assets to settle their debt.

Difference Between Liabilities And Expenses

A liability is money owed to buy an asset, like a loan used to purchase new office equipment. Expenses are ongoing payment for something without physical value or for a service.

An example of an expense would be your monthly electricity bill. But if you’re locked into a contract and you need to pay a fee to cancel it, this fee would be accounted for as a liability. 

Utilities for your store are an expense while the mortgage on your store is a liability.

Expenses are not found on a balance sheet but in an income statement (profit and loss account). Both are financial statements.

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