Liability (financial accounting)
Encyclopedia
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.
A liability is defined by the following characteristics:
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 is implied by a set of circumstances in a particular situation, as opposed to a contractually based obligation.
The accounting equation
relates asset
s, liabilities, and owner's equity
:
The accounting equation is the mathematical structure of the balance sheet
.
The Australian Accounting Research Foundation http://www.aarf.asn.au/ 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:
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.
Liabilities are debts and obligations of the business they represent creditors claim on business assests.
Example of Liabilities
All kinds of payable
1) Notes payable - a written promise.
2) Accounts Payable - an oral promise.
3) Interests Payable.
4) Sales Payable.
and are usually divided into two categories:
Liabilities of uncertain value or timing are called provisions - see Provision (accounting)
.
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. (The bank will record an ASSET when money is deposited, and their double-entry accounting correspondingly records an equal LIABILITY since the bank doesn't own the ASSET.)
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 debits 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 increased by the amount debited.
A liability is defined by the following characteristics:
- Any type of borrowing from persons or banks for improving a business or personal income that is payable during short or long time;
- A duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services, or other transaction yielding an economic benefit, at a specified or determinable date, on occurrence of a specified event, or on demand;
- A duty or responsibility that obligates the entity to another, leaving it little or no discretion to avoid settlement; and,
- A transaction or event obligating the entity that 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 is implied by a set of circumstances in a particular situation, as opposed to a contractually based obligation.
The accounting equation
Accounting equation
The basic accounting equation' is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits.In a corporation, capital represents the stockholders' equity.-In practice:...
relates asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s, liabilities, and owner's equity
Ownership equity
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
:
- Assets = Liabilities + Owner's Equity
The accounting equation is the mathematical structure of the balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
.
The Australian Accounting Research Foundation http://www.aarf.asn.au/ 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
International Accounting Standards Board
The International Accounting Standards Board is an independent, privately funded accounting standard-setter based in London, England.The IASB was founded on April 1, 2001 as the successor to the International Accounting Standards Committee...
(IASB). The following is a quotation from IFRS Framework:
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.
Liabilities are debts and obligations of the business they represent creditors claim on business assests.
Example of Liabilities
All kinds of payable
1) Notes payable - a written promise.
2) Accounts Payable - an oral promise.
3) Interests Payable.
4) Sales Payable.
Classification of accounting liabilities
Liabilities are reported on a balance sheetBalance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
and are usually divided into two categories:
- Current liabilities — these liabilities are reasonably expected to be liquidated within a year. They usually include payables such as wageWageA wage is a compensation, usually financial, received by workers in exchange for their labor.Compensation in terms of wages is given to workers and compensation in terms of salary is given to employees...
s, accounts, taxTaxTo tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
es, and accounts payableAccounts payableAccounts payable is a file or account sub-ledger that records amounts that a person or company owes to suppliers, but has not paid yet , sometimes referred as trade payables. When an invoice is received, it is added to the file, and then removed when it is paid...
s, unearned revenue when adjusting entriesAdjusting entriesIn accounting/accountancy, adjusting entries are journal entries usually made at the end of an accounting period to allocate income and expenditure to the period in which they actually occurred. The revenue recognition principle is the basis of making adjusting entries that pertain to unearned and...
, portions of long-term bonds to be paid this year, short-term obligations (e.g. from purchase of equipment). - Long-term liabilitiesLong-term liabilitiesLong-term liabilities are liabilities with a future benefit over one year, such as notes payable that mature longer 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...
— these liabilities are reasonably expected not to be liquidated within a year. They usually include issued long-term bondsBond (finance)In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
, notes payables, long-term leaseLeaseA lease is a contractual arrangement calling for the lessee to pay the lessor for use of an asset. A rental agreement is a lease in which the asset is tangible property...
s, pensionPensionIn general, a pension is an arrangement to provide people with an income when they are no longer earning a regular income from employment. Pensions should not be confused with severance pay; the former is paid in regular installments, while the latter is paid in one lump sum.The terms retirement...
obligations, and long-term product warrantiesWarrantyIn business and legal transactions, a warranty is an assurance by one party to the other party that specific facts or conditions are true or will happen; the other party is permitted to rely on that assurance and seek some type of remedy if it is not true or followed.In real estate transactions, a...
.
Liabilities of uncertain value or timing are called provisions - see Provision (accounting)
Provision (accounting)
In financial accounting, provision is a word that creates an ambiguous account title. In U.S. GAAP, provision means an expense, while in IFRS, International Financial Reporting Standards, it means a liability. So, in the U.S., Provision for Income Taxes means the same thing as Income Tax Expense,...
.
Bank account example
Money depositedDeposit account
A deposit account is a current account, savings account, or other type of bank account, at a banking institution that allows money to be deposited and withdrawn by the account holder. These transactions are recorded on the bank's books, and the resulting balance is recorded as a liability for the...
with a bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
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
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
for the depositor. (The bank will record an ASSET when money is deposited, and their double-entry accounting correspondingly records an equal LIABILITY since the bank doesn't own the ASSET.)
A debit
Debit
Debit and credit are the two aspects of every financial transaction. Their use and implication is the fundamental concept in the double-entry bookkeeping system, in which every debit transaction must have a corresponding credit transaction and vice versa.Debits and credits are a system of notation...
increases an asset; and a credit
Debits and credits
Debit and credit are the two aspects of every financial transaction. Their use and implication is the fundamental concept in the double-entry bookkeeping system, in which every debit transaction must have a corresponding credit transaction and vice versa.Debits and credits are a system of notation...
decreases an asset. A debit
Debit
Debit and credit are the two aspects of every financial transaction. Their use and implication is the fundamental concept in the double-entry bookkeeping system, in which every debit transaction must have a corresponding credit transaction and vice versa.Debits and credits are a system of notation...
decreases a liability; and credit
Debits and credits
Debit and credit are the two aspects of every financial transaction. Their use and implication is the fundamental concept in the double-entry bookkeeping system, in which every debit transaction must have a corresponding credit transaction and vice versa.Debits and credits are a system of notation...
increases a liability.
When a bank receives a deposit it credits a liability account called "deposits" and debits 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 increased by the amount debited.