What is Liability in Accounting
Two words, assets and liabilities are heard repeatedly in and around businesses. We published a guide on Business Assets: Definition, Type & More to help you understand such terms. This article will talk about all you need to know about liability.
What is a liability?
In business terms, liability is something that the company owes. Generally, it is an obligation or something that you owe somebody. Often times, liabilities are also defined as a company’s legal financial debts that arise in the entire course of business operations and growth.
Liabilities are recorded on the right side of the balance sheet <link> which includes components like loans, accounts payable, mortgages etc. In simpler words, liability means credit.
Types of liabilities
Primarily, there are three types of liabilities, current, non-current & contingent liabilities. Let’s dive deeper and understand what each of these means.
- Current liability: Also known as short-term liabilities, current liabilities are debts or obligations that need to be paid within a year. These need to be closely watched by the company to make sure that the company possesses enough liquidity to meet these debts or obligations.
- Non-current liability: Contrary to what current liabilities are, non-current liabilities are debts or obligations that are due in over a year’s time. They are an important part of a company’s long-term financing. Companies take long-term debt to acquire immediate capital to fund the purchase of capital assets or invest in new capital projects. These liabilities are crucial in determining a company’s long-term solvency. If companies are not able to repay their long-term liabilities, and if they become due, the company is likely to face a solvency crisis.
- Contingent liability: These are the liabilities that may occur, depending on the outcome of future events. These liabilities are also called potential liabilities. Consider this example to understand this better: when a company is facing a lawsuit of $100,000, the company would incur liability if the lawsuit proves successful. In case the lawsuit is not successful, no liability would arise.
In basic accounting standards, a contingent liability is only recorded if the liability is probable (50%+ likely to happen) and the amount of the resulting liability can be reasonably estimated.
Difference between expense & liability
An ‘expense’ is the cost of operations that a company incurs to generate revenue. Unlike assets and liabilities, expenses are directly related to the revenue and both are listed on a company’s income statement. In short, expenses are used to calculate the net income while liabilities are the indication of a company’s credit status.
For example, if a company has more expenses than revenues in its past three years, it may signal weak financial stability because it has been losing money for all those years.
Expenses and liabilities must not be confused with each other. One is listed on a company’s company’s income statement and the other is listed on the company’s balance sheet. Expenses are the costs of a company’s operation, while liabilities are the obligations and debts a company owes.
Examples of liabilities
To understand all of the above-mentioned information, let us take a practical case by having a look at this example:
Liabilities are one of the most vital aspects of a company because they are used to finance the operations and pay for large expansions.
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