What is Liability: Meaning, Types & Liabilities vs. Assets

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28 MARCH, 2024

A company's liability indicates its obligation to pay current or future financial debts, excluding equities to individuals or entities. Understanding the meaning of liability and managing it is crucial for businesses to mitigate risks and ensure financial stability.

What is a Liability?

Liability definition refers to an organization's legal accountability for paying monetary debts or some services that it owes to any individual, financial institution, or other business. Managing liabilities is critical since it affects a company's capacity to meet debts and remain viable. Proper liability management entails making strategic decisions to reduce risks and adhere to legal requirements, resulting in sustainable and responsible company operations.

How Liabilities Work

Liabilities are listed on a company's balance sheet and classified as current or long-term, depending on the due dates. Current obligations are expected to be paid off within a year, but long-term liabilities may require more time. Liabilities also aid in determining the business's capital structure and evaluating its liquidity.

Types of Liabilities

The Liabilities of any company are classified into two categories: current and long-term liabilities. This categorisation of liabilities is done based on the timeframe during which an organisation must settle them. Here is a detailed overview:

Current (Near-Term) Liabilities

Current liabilities, also known as short-term liabilities, encompass financial commitments that a company is mandated to settle within 12 months. Examples of current liabilities include payroll expenditures and accounts payable, which indicate sums owing to vendors, monthly utilities, and other charges. Apart from these, below are some additional instances of short-term liabilities:

Wages Payable: This obligation, which reflects employees' earned but unpaid revenue, varies regularly following regular pay cycles.

Interest Payable: Sometimes, businesses use credit to purchase goods and services. So, this liability demonstrates how much interest is required to be paid for using that credit.

Dividends Payable: Occurring quarterly for companies issuing dividends, this liability denotes the owed amount to shareholders following a dividend declaration.

Unearned Revenues: In this scenario, a company commits to providing goods or services at a later date, having received payment upfront. As indicated by an accounting record, this prepayment diminishes with each delivery of the goods or service.
Liabilities of Discontinued Operations: While often overlooked, this distinctive risk demands greater consideration. Companies are required to share the financial effect of activities, divisions, and other segments that are for sale or have just been sold. This includes the financial implications of pulling a product line from the market.

Non-Current (Long-Term) Liabilities

These types of liabilities are not obligated to be paid off in 12 months only and, therefore, are referred to as long-term liabilities. Beyond bonds and loans, businesses bear a variety of long-term liabilities, including rent, deferred taxes, salary, and pension liabilities. Additionally, some more examples of long-term liabilities are given below:

Warranty Liability: A company's obligation is to reimburse the expenses of repairs or replacements for items that fail to meet defined quality requirements throughout the warranty term. It indicates the projected future expenditures involved with fulfilling customer warranty claims.
Contingent Liability: A contingent liability is a probable obligation dependent on unpredictable future events, such as legal battles or environmental concerns.

Deferred Credits: These are liabilities that represent capital received in advance for services or goods that a firm has yet to provide. These are recorded as liabilities until the corporation meets its obligations.

Post-Employment Benefits: These are incentives that employees or their dependents may get upon retirement. These benefits are represented as long-term liabilities since they accumulate over time.

Unamortised Investment Tax Credits (UITC): This represents the variation between the initial cost of an asset and its cumulative depreciation. Classified as a liability, the unamortised portion roughly estimates the asset's reasonable current market value.

Liabilities vs. Assets

Understanding the distinction between liabilities and assets is essential for assessing an entity's financial health. Liabilities represent obligations and debts the company owes, while assets encompass resources and valuables owned or controlled. The table below illustrates the key differences between these two fundamental elements:

Criteria	Liabilities	Assets
Definition	Financial obligations and debts a company is liable to settle to another party	Resources owned by a company with future economic benefits
Nature	Represent claims against the company's resources	Signify the resources and value possessed by the company
Categories	Short-term (due within a year) and long-term (due beyond a year)	Current (short-term) and non-current (long-term) assets
Examples	Accounts payable, loans, deferred revenue	Cash, accounts receivable, property, equipment
Impact on Equity	Increases with additional liabilities	Increases with additional assets

Liabilities vs. Expenses

Liabilities and expenses are distinct financial elements. Liabilities reflect financial obligations, while expenses capture the operational costs incurred in the normal course of business. Here’s a table demonstrating the vital differences of these two terms:

Aspect	Liabilities	Expenses
Nature	Future financial obligations	Current period costs
Timeframe	It can be short-term (current) or long-term, depending on the obligation's maturity	Typically short-term, representing current operating costs
Recognition	Recorded on the balance sheet	Recorded on the income statement
Examples	Loans, accounts payable, deferred revenue	Rent, salaries, utilities, marketing expenses, etc.
Impact on Profit	Does not directly affect profit in the period incurred	Directly reduces profit in the period incurred
Relationship	Can result from past transactions or future agreements	Arise from day-to-day operations and resource usage

Example of Liabilities

For example, your company made an advance payment of Rs. 25,000 to make a website for a client. Until you deliver the website, this advance payment amount will be a liability.

Another instance is buying a phone for Rs. 20,000 on EMI with a downpayment of Rs 8,000. The remaining amount of Rs. 12,000+ interest is a liability until it is paid, and with each EMI, the liability is reduced.

FAQs About Liability

What are liabilities in business?

Liabilities in business are the financial commitments and debts owed to external parties. They include current obligations, expected to be resolved within a year, and long-term liabilities, which extend beyond that timeframe. Some examples of liabilities are accounts payable, loans, and accrued expenses.

What is contingent liability?

A contingent liability is a potential financial obligation that may occur depending on the outcome of uncertain future events.

What are current liabilities?

Current liabilities are financial commitments and debts that a company is required to repay within 12 months.

What is the relationship between liabilities, assets, and equity?

Liabilities, assets, and equity are interconnected components on a company's balance sheet. Assets represent what a company owns, liabilities signify its financial obligations, and equity is the remaining stake of the owners.