Lesson Objectives:- Defining the characteristics of a liability
- Examples of liabilities
- Where liabilities are recorded on financial statement
On the balance sheet, we have three main elements: assets, liabilities and equities. In the previous lesson we dug into the characteristics and examples of assets. Now, let's look at what a liability is and how it is used in financial accounting.
Right off the bat, the word liability portrays a negative thought because it can seem like a burden. It is something that consumes the company's funds and puts them in a position to make an economic sacrifice.
Liabilities are a vital part of a company's finances as they help to fund operations and expansion. A liability is commonly thought of as debt or loans, but there are additional types of accounts such as accounts payable, accrued expenses and deferred revenues.
In short, a liability is an obligation that is considered a debt or obligation that is owed against a company's assets. Ultimately it is something the company is responsible for and it is often based on contractual obligations.
In the world of accounting, every liability has an assigned value. As you can see in the balance sheet snapshot above, businesses separate their liabilities into current, or short-term and long-term liabilities. Other types of accounts such as accrued expenses, accounts payable and payroll expenses are listed on the balance sheet.
Many companies, especially startups need additional capital to fund rapid growth. A short-term debt is often paid within a year time period while long term debts are paid for larger time periods such as a 15 or 30-years.
The liabilities are always listed on the opposite side of the assets on the balance sheet. Above is a very simple example that shows the placement of liabilities on the balance statement.
The main criteria for defining a liability relies on three simple attributes:
1. Something that is owed.
2. Responsibility or obligation
3. Probable economic sacrifice will be made in order to settle the transaction
Liabilities exist within many different types of transactions for items such as debt, payroll, taxes, contracts and warranties. When looking at examples of liabilities, you will find that it is much easier to quantify liabilities than it is to put an accurate value on assets.
Understanding where the liabilities in your company sit will help management to decide on how to better control and potentially reduce them.
• The supplier of point-of-sale registers to large grocery stores invoices the store for a shipment of 20 registers valued at $200 per unit. The $4,000 total amount is recorded as an accounts payable liability to the store.
• An electronics store sells a 3-year warranty with their TV's valued at $599 and up. The amount of the warranty liability is determined by estimating the value of the warranty over the 3-year period.
• A landscaping company is expanding locally and takes out a short-term loan for $10,000 to fund the purchase of new equipment. They are liable for the debt owed on the loan.
• The bank uses a mortgage for $300,000 at an 8% interest rate for a 15-year period. In this case, the company is liable for the interest payable for the long-term liability.
Financial accounting liabilities are often unavoidable. It is hard to run a successful business without borrowing money or having obligations.