Liability: Definition, Types, and Examples

Did you know that liabilities play an important role in the overall growth of every company? With the right amount of liabilities, you can finance operations and pay for large expansions.

Most people only know the negative aspect of liability and don’t consider how this frequently misunderstood business term can help grow your business.

This article aims to expand your knowledge about the definition, type of liabilities, and various examples of liabilities.

Are you ready? Let's begin.

What is Liability?

Liabilities are debt or obligation, now or in the future. A liability is a non-depreciable value that someone or a company owes and includes taxes, accounts payable, bonds, employee wages, and long-term loans.

For example, a business owner obtains a loan to purchase valuable assets or to expand his business, hoping to pay after some time. This time frame might be short-term or long-term, which are the two main types of liabilities.

Liabilities are great and give businesses economic benefits and opportunities to thrive. Owing debts can also be risky. A company might go bankrupt if they have more liabilities than assets.

Smart business owners prioritize keeping assets above liabilities. If you want to check the financial performance of a company in relation to assets and liabilities, check the balance sheet.

Balance Sheet Example — **Source:** **Accounting Play**

How Do Liabilities Work?

Liabilities work when a company realizes that there is a great need for external funding. This funding helps businesses generate cash flow and purchase equipment to speed up their production process.

Before this process commences, the executives of a company will deliberate on its financial state. If the state is favorable to acquiring debt and an agreement is made, they will explore the options available.

This decision is very crucial as they might still be owing current debts to be paid shortly. For example, A company might go for long-term loans if the market is in its favor. If all hands are on deck, they will make enough profits, which will outweigh their debts and keep them far ahead.

Types of Liabilities

Businesses generally divide types of liabilities into current and long-term liabilities. But there is another time of liability called contingent liability.

Let’s explore these three different types of liabilities;

1. Current Liabilities

Current liabilities refer to a company’s short-term financial obligation payable in a few months or a year. For example, income tax is imposed by the federal government on a company depending on income earned and their jurisdiction.

This type of liability is paid within a normal operating cycle. A normal operating cycle is the time frame needed to convert money to raw materials, finished products, sales, accounts receivable, and money back again.

Examples of current liabilities include short-term loans, accounts payable, income taxes payable, dividends payable, accrued expenses, customer deposits, and notes payable.

Another name for current liabilities is short-term liabilities because they have about a twelve month duration for payment. On the other hand, long-term liabilities extend beyond a year.

The working capital of a company is obtained by subtracting the current liabilities from the current assets. If the liabilities are more, the working capital of the company is reduced.

This form of liability is less risky as the time of payment is shorter and immediate. It is easier for a company to pay a debt in three months than to meet up with debts extending beyond a year or even more.

Current liabilities have lower interest rates in comparison with non-current or long-term liabilities. The long-term nature of non-current liabilities results in high interest rates.

Current Liabilities Formula — **Source:** **EDUCBA**

2. Contingent Liabilities

Contingent liabilities occur as a result of uncertain future events. You can refer to it as potential liabilities. Businesses track contingent liability using accounting software.

Risks of contingent liabilities are uncertain since they are dependent on future occurrence, and there are no interest rates until the liability occurs.

A contingent liability is recorded as a current liability on an event of its occurrence. Lenders take contingent liabilities into account to determine the financial state of the company.

Categories of contingent liabilities according to GAAP (Generally Accepted Accounting Principles) include probable, possible, and remote.

Probable contingency means that it is likely to occur. It can be estimated.
Possible contingency is not more likely to occur, but at the same time, is not considered unlikely.
Remote contingency means there is a high possibility of it not occurring.

Examples of contingent liabilities include lawsuits (legal liability), product warranties, and environmental spills.

Accounting Treatment of Contingent Liabilities

3. Long-term Liabilities

Long-term liabilities are financial obligations of a company that extends more than a year. These liabilities affect a company’s financial structure because they indicate the amount of debts you have acquired to finance your assets and business operations.

Other names for long-term liabilities are non-current liabilities and long-term debts because it takes a while before your organization can settle them.

A long-term liability appears in the form of bonds payable, mortgage loans, and deferred tax liabilities.

Bonds payable is simply defined as when a company issues bonds to get cash.
A mortgage loan is a loan borrowed on an agreement between the lender and the borrower that gives the lender a formal right to take the property of the borrower if the money plus interest owed isn't paid at the due date.

A mortgage loan is not the same as a mortgage payable. This loan is when a property is used as collateral for obtaining the loan. Mortgage loans, like most loans, are broken down into monthly payments over the period agreed.

Mortgage payable is a type of long-term debt for purchasing property for business activities. Long-term liabilities have higher interest rates due to the wide gap between the time of borrowing and repayment. They require strategic planning over a long period.

Liabilities vs. Assets

Meaning

Liabilities are obligations that a company owes financial institutions, expected to be paid at the maturity date. A company’s assets are economically valuable resources used to get more future benefits.

Impact on Financial Net Worth

Liabilities impact negatively on the financial net worth of a business or company, while assets impact positively and increase the financial net worth of a business or company.

Position on Balance Sheet

You record liabilities on the right side of the balance sheet while you record assets on the left side of the balance sheet.

Accounting Equation

The accounting equation for Liability is Total Liability = Total Assets – Shareholder Equity, while the accounting equation for Asset is Total Assets = Total Liability + Shareholder Equity.

Liabilities vs Expenses

Meaning

Liability is the money that a business owes a financial institution. Expenses are day-to-day costs a company is expected to pay, such as salaries. These costs arise as a result of business operations.

Type of Financial Statement Used

Businesses record liabilities on the company’s balance sheet and record expenses in income statements.

An income statement, also known as a profit and loss account, reflects the company’s expenses and revenues within a particular time frame. Both balance sheet and income statements are types of financial statements.

Internal or External

Liabilities are external because they involve outside parties. Expenses are internal because they involve costs by the company during business transactions.

Assets or Revenue

Liabilities help acquire assets, while expenses help generate revenue.

Examples of Liabilities

Loans Payable: Liabilities recorded in a company’s balance sheet as a result of money borrowed from lenders, which has to be paid in the future. It is called loan payable because it is “payable” by the company.
Unearned Revenue: A type of current liability in which a company receives money for goods it has not yet delivered to a customer. Another name for unearned revenue is prepaid revenue.
Short-Term Loans: Loans obtained to take care of immediate and urgent needs. Sources for short-term loans include trade credits, secured loans, and merchant cash advances.
Accrued Expenses: When a company obtains or incurs assets and pays for them later. An example of an accrued expense is rent expense, the cost of an office space or building used for business transactions.
Customer Deposits: When a customer pays ahead of obtaining goods or services from a company. For example, a customer can pay a fashion company ahead for shoes he or she intends to wear for a wedding occurring in two months.
Notes Payable: Notes or agreements written by two parties (e.g. a company and financial institution) containing details of time and money agreed by one party to pay another. You can refer to notes payable as promissory notes or loans.
Accounts Payable: Money owed by a business or company as a result of collecting goods and services from suppliers, expecting to pay at a later date. A beverage company can have an agreement with farmers to obtain cocoa, expecting to pay after profits have been made.
Income Taxes Payable: Taxes a company is expected to pay over a year. Income taxes payable are based on the requirements of the government where it is located. Income taxes payable are a current liability.
Dividends Payable: Amount agreed to pay to qualified company shareholders but hasn't been paid yet. Dividends payable is a current liability and it is recorded on the company’s balance sheet.

FAQs

How Do I Know If Something Is Liability?

Whatever entails current debts or financial burden is a liability. They are obligations you need to pay in the future. It falls under the category of things you owe or borrow, including short-term loans and long-term loans.

How Are Current Liabilities Different from Long-Term Ones?

Current liabilities are liabilities that fall within a year. They include bank account overdrafts, short-term loans, interest payable, and accounts payable. Long-term liabilities or non-current liabilities extend more than a year. Examples include mortgage loans and bonds payable.

What is Contingent Liability?

Contingent liabilities are types of liabilities that may or may not occur depending on the outcome of a future event. For example, a company might be sued for environmental spills. If they are found to be guilty, they would have to pay for damages.