What are liabilities in accounting?
Peter Baskerville
The definition and application of 'Liabilities' in Accounting - Foundation level
Liabilities are the financial obligations and debts of an entity arising from past
transactions and occurring during the course of business operations. These financial
obligations are paid by the accounting entity to external parties over time via the transfer
of economic benefits including money, goods or services. External parties include
banks, other financial institutions, creditors and government agencies. Liabilities include
credit card debt, overdrafts, accounts payable, term loans and mortgages.
'Liabilities' in Accounting
Accounting entity assumption and 'liabilities'.
To understand 'liabilities' we must first revisit the 'accounting entity assumption'. The
'accounting entity assumption' states that in accounting, a business must be treated as
a distinct entity. The business, as a distinct entity, will record its financial transactions in
a separate book of accounts to that of the owners of the business. By applying the
'accounting entity assumption', the business is able to give accurate reports on its own
financial position and performance. The 'accounting entity assumption' also determines
the perspective that the business will take when recording financial transactions.
We know that a business is created to make profits for the owners of that business.
Now when the business is first created, it owns nothing in its own right and it owes
nothing to anyone. It is an empty shell. However, from this point on, the business will
view every financial transaction from its own perspective. It will not record transactions
from the owner's perspective.
The first transaction a business records into its books of account, is the initial
investment of funds by the owners of the business. These investment funds, that are
provided to the business by the owners, are called 'owners equity'. 'Owners equity'
funds remain in the business until the business ceases to trade. The business views
these funds as belonging to the owners but the business is not obliged to repay them.
'Owners equity' funds are investment funds. Investment funds entitle the owners to all
the profits that the business makes. 'Owners equity' funds are known as Equity Funds.
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Soon after the business is created it also receives funds that are provided by nonowners. Banks and suppliers are typical non-owners who provide funds to the business.
Funds provided to the business by non-owners are called 'liabilities'. The business
acknowledges that these funds belong to the non-owners and understands that the
business is obliged to repay them. 'Liability' funds are known as Debt Funds. Debt funds
do not entitle the fund providers to any profits that the business makes. However,
sometimes debt fund providers will receive an interest payment for the funds provided.
The business will then use both the Equity funds (Owners equity) and the Debt Funds
(Liabilities) to purchase assets. Assets are those items of financial value that the
business will use to make profits for the owners. Typically assets include equipment,
inventory and cash reserves. So, from the business perspective, the value of the assets
the business controls must be equal to the combined value of the Equity funds (owners
equity) and the Debt Funds (liability). The relationship between assets, liabilities and
owners equity is known as the accounting equation.
Liabilities in accounting
Definition of 'liabilities in accounting.
Liabilities are the monies that a business is obliged to repay to others. Some
characteristics of 'liabilities are:
1. Liabilities are funds provided to a business mostly by non-owners.
2. Liabilities are also known as the debts of a business.
3. Liability funders (Debt Funders) are not entitled to the profits of the
business.
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4. Liability funders (Debt Funders) are sometimes entitled to interest
on the unpaid debt.
5. The business uses Debt funders to purchase assets.
6. Liability funders (Debt funders) have certain claims over the assets
of the business.
7. Liabilities are typically loans owing to financial institutions, money
owing to suppliers (Creditors) and payments owing to governments
(Taxes).
8. When the assets of a business are liquidated, the debts are paid
first. The Equity funders are entitled to what money is left over.
The Australian Accounting Research Foundation defines liabilities as: "future sacrifice of
economic benefits that the entity is presently obliged to make to other entities as a
result of past transactions and other past events."
Types of 'liabilities in accounting.
There are three main types of 'liabilities' in accounting:
1. Current liabilities
2. Non-current liabilities - sometimes known as 'Long-term' liabilities
3. Contingent liabilities
Current liabilities are short-term financial obligations. Short-term is defined as
obligations that are required to be paid off within one year. Current liabilities are
recorded in the Statement of Financial Position (Balance Sheet). Typical current
liabilities include expenses due but not yet paid (wages, taxes, and interest payments),
accounts payable to suppliers, short-term notes and revenues collected in advance.
Non-current liabilities are long-term financial obligations. Long-term liabilities are not
required to be paid off within a year. Long-term liabilities often involve large sums of
money that allowed the business to open or expand or purchase a significant
asset. Non-current liabilities are recorded in the Statement of Financial Position
(Balance Sheet). These debts will typically take the business a long time to repay.
Typical long-term liabilities include mortgages over property, a bank term loan or lease
obligations for vehicles or equipment.
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Contingent liabilities are a third kind of liability that typically affects large public
companies. A contingent liability is a non-measurable liability that a company has for an
adverse event, transaction, or incident that has already taken place. Contingent
liabilities are reported in the notes to the accounts. Contingent liabilities are not usually
recorded in the Statement of Financial Position (Balance sheet) of the business. Typical
contingent liabilities could be a lawsuit taken against a company or an environmental
cleanup responsibility or new regulations or penalties that could impact on the company.
Source URL: http://knol.google.com/k/what-are-liabilities-in-accounting#
Saylor URL: http://www.saylor.org/courses/bus103/
Attributed to: Peter Baskerville
Saylor.org
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