Accountancy Liability Accounts, Liability Accounts Accounting, Liability Obligation

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Liability Accounts
In the most general sense, Liability Accounts are anything that is a hindrance, or puts individuals at a disadvantage of some kind.

In financial accounting, Liability Accounts are defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future.

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

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Each account in the Anglo-Saxon chart is classified into one of the five categories:
Assets, Liabilities, Equity, Income and Expenses.

A chart of accounts is a listing of the names of the accounts that a company has identified and made available for recording transactions in its general ledger.

Liability, and accounts it contains, is something possessed by a business entity from which future sacrifice of economic benefits may be obtained now.


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Liability Characteristics

In financial accounting, a Liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future. Liabilities have three essential characteristics:

  1. They embody a duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services or other yielding of economic benefits, at a specified or determinable date, on occurrence of a specified event, or on demand.

  2. The duty or responsibility obligates the entity leaving it little or no discretion to avoid it.

  3. The transaction or event obligating the entity has already occurred.

Liabilities in financial accounting need not be legally enforceable; but can be based on equitable obligations or constructive obligations. An equitable obligation is a duty based on ethical or moral considerations. A constructive obligation is an obligation that can be inferred from a set of facts in a particular situation as opposed to a contractually based obligation.

The accounting equation relates assets, liabilities, and owner's equity:

  • Assets = Liabilities + Owners' Equity.

The accounting equation is the mathematical structure of the balance sheet.

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.

Probably the most accepted accounting definition of liability is the one used by the International Accounting Standards Board (IASB). The following is a quotation from IFRS Framework:

A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

Regulations as to the recognition of liabilities are different all over the world, but are roughly similar to those of the IASB. Examples of types of liabilities include:
money owing on a loan, money owing on a mortgage, or an IOU.


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Classification of Liabilities

Liabilities may be classified in many ways. In a company's balance sheet certain divisions are required by generally accepted accounting principles (GAAP), which vary from country to country.

Generally, Liabilities are reported on a balance sheet and are usually divided into two categories:

Current Liabilities

Current Liabilities are reasonably expected to be liquidated within a year. They usually include payables such as wages, accounts, taxes, and accounts payables, unearned revenue when adjusting entries, portions of long-term bonds to be paid this year, short-term obligations (e.g. from purchase of equipment), and others.

In accounting, current liabilities are considered liabilities of the business that are to be settled in cash within the fiscal year. For example accounts payable for goods, services or supplies that were purchased for use in the operation of the business and payable within a normal period of time would be current liabilities. Bonds, mortgages and loans that are payable over a term exceeding one year would be fixed liabilities.

However the payments due on the long-term loans in the current fiscal year could be considered current liabilities if the amount were material. The proper classification of liabilities is essential when considering a true picture of an organization's fiscal health.

Long-term Liabilities

Long-term Liabilities are reasonably expected not to be liquidated within a year. They usually include issued long-term bonds, notes payables, long-term leases, pension obligations, and long-term product warranties. Liabilities of uncertain value or timing are called provisions.

Long-term liabilities are liabilities with a future benefit over one year, such as notes payable that mature greater than one year. In accounting, the long-term liabilities are shown on the right wing of the balance-sheet representing the sources of funds, which are generally bounded in form of capital assets.

Examples of long-term liabilities are debentures, mortgage loans and other bank loans (note: not all bank loans are long term as not all are paid over a period greater than a year, the example is bridging loan).

By convention, the portion of long-term liabilities that must be paid in the coming 12-month period are classified as current liabilities. For example, a loan for which two payments of $1000 are due, one in the next twelve months and the other after that date, would be 'split' into two: $1000 would be classified as a current liability, and $1000 as a long-term liability (note this example is simplified, and does not take into account any interest or discounting effects, which may be required depending on the accounting rules).


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Liability in Law

In law a legal liability is a situation in which a person is liable, such in situations of tort concerning property or reputation and is therefore responsible to pay compensation for any damage incurred; liability may be civil or criminal. See Strict liability. Under English law, with the passing of the Theft Act 1978, it is an offense to dishonestly evade a liability. Compensation for damages usually resolved the liability. Vicarious liability arises under the common law doctrine of agency – respondent superior – the responsibility of the superior for the acts of their subordinate.

In commercial law, limited liability is a form of business ownership in which business owners are legally responsible for no more than the amount that they have contributed to a venture. If for example, a business goes bankrupt an owner with limited liability will not lose unrelated assets such as a personal residence (assuming they do not give personal guarantees). This is the standard model for larger businesses, in which a shareholder will only lose the amount invested (in the form of stock value decreasing).

Manufacturer's liability is a legal concept in most countries that reflects the fact that producers have a responsibility not to sell a defective product.


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Bank Account Example

Money deposited with a bank becomes a liability of the bank, because the bank has an obligation to pay the depositor the money deposited; usually on demand. (The money deposited is an asset for the depositor; but this asset will not be recorded by the bank because it is not the bank's asset. If the depositor maintains accounting records separate and apart from the bank account maintained by the bank, only then will the asset be recorded).

A debit increases an asset; and a credit decreases an asset. A debit decreases a liability; and credit increases a liability.

When a bank receives a deposit it credits a liability account called "Deposits" and credits the depositor's bank account for the same amount (the bank's "Deposits" account is the sum of all of the amounts credited to all of its customer's individual bank accounts). A deposit received by a bank is credited because the bank's liability to its customer, the depositor, increases. When a bank informs its depositor that it has debited the depositor's bank account, it means that the depositor's bank account has been decreased by the amount debited.


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Business Tips

Some tips on how to avoid business failure:

  • Don't underestimate the capital you need to start up the business.

  • Understand and keep control of your finances - income earned is not the same as cash in hand.

  • More volume does not automatically mean more profit - you need to get your pricing right.

  • Make sure you have good software for your business, software that provides you with a good reporting picture of all aspects of your business operations.


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Important Note
Because the material covered here and other pages is considered an introduction to the topic of Accountancy and Accounting, there are many complexities not presented. You should always consult with a business accounting professional for assistance with your own specific circumstances.


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