Liability is defined as the company’s obligations or debts that arise during the course of business operations. It is nothing but the sum owed to the creditors for any past transaction that has occurred. They also include the revenues that the company is yet to receive the goods or services rendered. As the revenue is not yet realised in the company’s books of accounts it is classified under the category of liabilities. When liabilities are lessened from the assets the equity of the firm is determined:
Owner’s equity = Assets – Liabilities
To make one understand the best example is of the money we deposit with banks which in turn provide us with the interest as per the rates. It is an asset for us as it increases our earnings and it is similarly a liability to the bank as has an obligation to pay us the promised interest at regular intervals. As the bank does not own the deposit it becomes a liability to them.
A debit entry will decrease the value of the liability and in a similar way a credit entry will increase the value of the liability.
There are majorly two types of liabilities:
- Current liability: this essentially includes all the list of items that need to be paid within the span of one year. For firms who have their operating cycle more than a year then current liabilities will have to be paid within that longer cycle. Few examples will be salaries, bank loans, taxes etc.
- Long term liability: this includes all the items that need not be necessarily paid within one year. They can take longer periods of time to be settled. Few examples will be pension, capital leases, long-term bonds etc.
- Contingent liability: Though this kind of a liability may or may not occur this is also considered as a category. This includes all the items where the firm is paying in case of long term legal issues like fines.
Characteristics of a liability:
- It’s the sum which is borrowed from someone outside the firm with an assurance that the same will be returned in an agreed frame of time. Both the parties agree on the time frame and mode of settlement.
- Payment for a service or a transaction which has already commenced and needs to be financially settled.
- An assurance which permits settlement by future transfer of goods of the provision of services or a transaction which can generate money.
Accounting of liabilities:
Liability is always accounted on the right side of the balance sheet. The major list of liabilities are as given below:
Accounts payables: This is a current liability. It is an entry which represents the short-term debts which if not paid on time can lead to default. Few examples include bills, salaries, short-term bank loans etc.
Notes payables: it includes the principal amount which needs to be paid on the basis of a formal written promise. Bank loans are included here.
Accrued expenses: It majorly covers all the expenses that the company has already incurred but which has not yet been entered in the books of accounts and which is not yet paid. Few examples which can be included here are taxes incurred where the invoice is yet to be received, wages incurred which are not yet paid to the workers, goods received which are already consumed or further sold and for which the supplier has not yet sent an invoice or interest on loans which is awaiting an invoice from the bank.
Unearned revenues: it is a liability which shows the payments done in advance. Few examples for this are advance rent payments, advance contract payments, prepaid insurances or taxes. It is also known as prepaid revenue. Once the revenue is realised the firm will debit the balance in the unearned revenue account and credits the balance in the revenue account. It has to be treated in this way or else the firm will show over-determined revenues and upon realisation will have to show underdetermined revenues which will affect the matching principle.
Customer deposits: it is an account in the books of accounts of the firm where advance cash is given for an agreed delivery of goods or provision of services in a certain manner. It is a debit to cash and a credit to customer deposits entry in the books.
Interest payable: This is a current liability which accounts all the interests which are payable as per the balance sheet date. Future interests are not considered in this entry.
Warranty liability: this is more of a contingent liability expense which will probably occur or may not occur at all. This account provides an estimated amount of expense that the firm will incur in order to repair or replace the products during its warranty period. The expense is recorded at the time of selling the product is when the expense is actually realised and reported.
Salaries/wages payable: This is again a current liability wherein the firm will have to pay their employees the fixed salary/wages for the services rendered by them.
These are some of the main items that appear in the liabilities list. There might be few others like utility payments, tax payments and so on and so forth. They have to be accounted according to their commencements. There will be few adjusting entries as well. The accountant will have to keenly track the transactions as the same will reflect in the balance sheet. For example, if the firm has received the goods or any repairs done from the respective vendor and the invoice is not yet received an entry will still be required to mark this as per the accrual accounting system. The firm will be required to place an adjusting entry in the balance sheet. An income statement account will need to be created for this expense recording.
Similarly, the firm should maintain a detailed list of liabilities and use adjusting entries as and when required. All in all accounting liability needs an observant and keen accountant.