Liabilities are a component of the accounting equation. It can be informally defined as “how much lenders lent the company”, or “how much the business owes to outsiders”. The more formal definition is the “economic obligations of the business to outsiders”.
Examples of Liabilities
Here are some examples of liabilities:
- Bank overdraft: the business obtained a short-term loan from the bank
- Accounts payable: the business bought inventory from the suppliers but has not paid yet.
- Notes payable: the business borrowed money by issuing promissory notes
- Loan from bank: the business borrowed money from the bank
- Debentures: the business borrowed money by issuing debentures
In each of the cases, the business is obligated to repay the bank/ suppliers/ other lenders by giving up some of its economic benefits.
Like assets, liabilities can be current or non-current. Current liabilities are those that have to be settled in the coming year, while non-current liabilities fall due over a year later. Bank overdrafts and accounts payable are usually classified as current liabilities, while the rest depends on the specific situation.
There is also a special type of liability worth mentioning: provisions. While the word “provision” itself can have a lot of meanings, it denotes “a liability of uncertain timing or amount” in this context.
Say you have started a coffee shop. A few customers fell sick after visiting your shop. They filed a lawsuit, trying to sue your shop. Your legal adviser suggested that your business will have to pay an estimated $2,000 in compensation. In this case, you can be reasonably sure that your shop has an obligation to pay that $2,000. In essence, your shop owes the customers that $2,000 even before the lawsuit comes to an end. This $2,000 is a liability. Since you are not sure of how much your shop has to pay exactly (the lawsuit is still in progress) and when it has to settle the amount, a provision of $2,000 will be recorded.
Let us consider another scenario. A customer named Bob visited your shop. Two weeks later, he got a headache and claimed that he felt unwell because of drinking a cup of coffee from your shop. Bob filed a lawsuit and demanded a $10,000 compensation.
This time, you can be sure that your shop will win the lawsuit and hence your shop will not have the obligation to pay Bob. In this case, your shop will not record the $10,000 as a liability.
Now that you have come to know more about liabilities, you will be able to start learning about financial statements, which is what financial accounting is all about!
Horngren, C., Sundem, G., Elliott, J., & Philbrick, D. (2014). Accounting: The Language of Business. In Introduction to Financial Accounting (Eleventh ed., p. 9).