Liability - Definition and Types

What is Liability?

Liability is a term in accounting that is used to describe any kind of financial obligation that a business has to pay at the end of an accounting period to a person or a business. Liabilities are settled by transferring economic benefits such as money, goods or services.

Liabilities are recorded on the right hand side of the balance sheet, which includes different types of loan, creditors, lender and suppliers.

Liabilities can be of short term and long term. Short term liabilities are due within an accounting period (12 months) and long term liabilities become due within a duration of more than 12 months.

Types of Liabilities

Liabilities can be classified into three main categories, which are:

1. Current Liabilities

2. Non-current Liabilities

3. Contingent Liabilities

Current Liabilities: Current liabilities are those liabilities that are due and need to be paid within an accounting period (which is usually a year or 12 months). Current liabilities are also known as short-term liabilities due to the relatively short turnaround time.

Current liabilities need to be closely monitored by the management of a company as a company needs to have sufficient liquidity in the form of current assets in order to pay off the current liabilities.

Current liabilities have a direct impact on the working capital and also on the liquidity of the business.

Some of the examples of current liabilities are:

1. Interest Payable

2. Accounts Payable

3. Short term loans

4. Accrued Expenses

5. Bank overdraft

Non-Current Liabilities: Non-current liabilities, which are also known as long term liabilities are financial obligations that are due in over a year’s time. Long term liabilities play an important role in the long term financing of the business.

These liabilities help businesses acquire capital assets by providing the required capital. Businesses can also invest in new capital projects using the funds obtained from long term debts or liabilities.

Long term liabilities are an important indicator of the solvency of the business. A company which is unable to pay off long term liabilities as and when they become due, indicates a solvency issue with the business or it signals a crisis within the business.

Investors always look at the long term liabilities of the business before investing.

Some examples of long term liabilities are:

1. Deferred tax liabilities

2. Bonds payable

3. Capital leases

4. Debentures

Contingent liabilities: Contingent liabilities are a special type of liability that may occur during the course of a business, depending on the outcome of an event that may take place in the future.

In accounting standards, contingent liabilities are recorded as potential or probable liabilities only if they have a 50% chance of occurring and when the amount of liability can be estimated properly.

Some of the examples of contingent liabilities are:

1. Product warranties

2. Lawsuits

Relation between Assets and Liabilities

Assets and liabilities are very closely related. For determining owners equity or shareholders equity, the total liabilities are subtracted from total assets. Also, the businesses which earn benefits in the short term from the current assets, use those assets for paying off the current liabilities.

The formula for shareholders equity shows

Shareholders equity or Owner’s equity = Total Assets – Total Liabilities

This was all about the topic of Liabilities – Definition and Types, which is an important topic of Accountancy for Commerce students. For more such interesting articles, stay tuned to BYJU’S.