What is a Liability?
- A liability is a debt. An entity that has a liability has an obligation to pay its debt in some or another way. Liabilities take away from the net worth of an entity, in the same way that assets add to it.
- Liability
Examples of liabilities include credit card debt, personal loans, mortgages, IOUs and income tax that still needs to be paid.
Liabilities can be classified in several ways:
Liabilities come about because of transactions or events that leaves the entity owing a debt.
Examples of such transactions and events are: borrowing money, getting a service without paying for it up-front, earning a profit on which tax still needs to be paid and entering into an agreement to give or do something to or for someone else.
All liabilities come with an obligation to pay another entity. The payment can take place either by transferring assets, or by delivering a service to the entity.
Current and Long-term Liabilities
- Current liabilities (also called “short-term liabilities”) are liabilities that will most likely be paid in less than a year. These liabilities are usually incurred during the day-to-day activities of the entity and they’re not meant to be liquidated (paid off) within a short period of time.
- Current liabilities
Current liabilities include accounts payable (e.g. property tax account, electricity account, mobile phone account, etc.), oustanding taxes, credit card debt and other short-term debts (e.g. a hi-fi that has to be paid off over 12 months), wages payable, outstanding taxes, unearned revenues (payments received before revenues were actually earned) and portions of long-term bonds that needs to be paid within a year.
- Long-term liabilities are liabilities that will most likely exist for more than a year. These liabilities are made infrequently, they’re usually significant (i.e. large) and they are meant to be liquidated (paid off) over or after a few years.
- Long-term liabilities
Long-term liabilities include long-term bonds, mortgages and leases that will be paid over several years.
Provisions for Expenses
- A provision is a temporary liability for an expense that should be recorded at a certain time, even though it is only paid later. Provisions are used in accounting to make sure that expenses are recorded for the correct time period.
- Provision
Provisions are used to make the books work out correctly.
E.g. if you incur a business expense for February, but it is only paid during March. To record this, you debit the expense account and credit the provision (liability) account in February. Then, when payment is made, you credit the account from which payment was made, and debit the provision account (effectively closing the provision account).
This may seem a odd thing to do, but it can have huge implications. E.g. if an expense for a company falls within a certain tax year, but is only paid and recorded for the next tax year. In this case the company will have to pay more tax than it needs to for the first tax year, because it will show a larger profit.
Note that the definition of a “provision” is ambiguous. According to U.S. GAAP, provision means an expense, while according to the International Financial Reporting Standards (IFRS), it means a liability. The definition I gave here falls in line with that of the IFRS.
Legal and Non-legal Liabilities
- A legal liability an obligation to pay a debt, that is bound by law. Legal obligations can be contractually bound, bound through commercial law, or bound through common law.
- Legal liability
Most liabilities fall into the legal category. For most transactions where a debt is incurred (i.e. a liability is created), there will be some formal process to make it legally binding. The most common way to do this is by drawing up a contract.
There are also other legal liabilities that are incurred through law. E.g., when someone does something that causes someone else to incur damages, by law the first person can incur an obligation to compensate the victim for the damages he/she suffered.
- A non-legal liability is an obligation to pay a debt, that is not bound by law. Such liabilities can be based on equitable obligations (obligations that are based on ethical or moral considerations), or constructive obligations (obligations that can be deduced from a set of facts, even though there is no formal contract in place).
- Non-legal liability
Liabilities can be incurred, even though they are not legally binding. E.g. if a member of your family does something that causes someone else to suffer a loss, you may incur an equitable obligation and decide to make good for mistakes of your family, even though you are not legally responsible.
This definition is part of the Dictionary of Financial Terms. If you want to receive a notice every time a new definition is published, you can subscribe to Liberta.
