- In this video you'll find out what liabilities
mean in accounting.
I'm going to explain the definition
and take you through the common types of liability
that are worth knowing about,
with examples to make things clearer.
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Hey viewers, I'm James, and welcome to Accounting Stuff,
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you need to know about accounting and bookkeeping.
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then check out my Accounting Basics playlist up here.
That will start you off with video number one.
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Last week we discussed the meaning of assets in accounting.
Link up here if you missed it.
And in today's video we're going to talk about liabilities,
the second pilar in the accounting equation.
Assets are equal to liabilities plus equity.
Liabilities can be broke down broadly
into three categories,
current liabilities, non-current liabilities,
and contingent liabilities.
We'll explore the meaning
of all of these terms in this video.
And, I don't know why but the word liabilities
always makes them seem like a bad thing.
Like, something we want to avoid.
But that is not the case.
Liabilities are just a normal part of business.
They aren't anything to be afraid of.
And I'm going to explain why right now.
Hold on tight because you're about to hear
the full accounting definition of liabilities,
and it aint pretty.
Liabilities are probable future sacrifices
of economic benefits arising from present obligations
of a particular entity to transfer assets
or provide services to other entities in the future
as a result of past transactions or events.
What the?
I thought the assets definition was bad,
but this is something else.
Let's break it down and see if we can make any sense of it.
Liabilities are probable future sacrifices
of economic benefits.
The word probable hints at uncertainty.
When dealing with liabilities,
we accountants often have to use our own judgment
of situations to estimate future outcomes.
This is especially the case with accruals,
which I'll get into later in this video.
Future sacrifices means that we're going to need
to give up something in the future.
And what are we gonna give up?
Economic benefit,
which relates to the things that have value,
or more specifically, assets and services.
And that doesn't only mean cash.
This definition also says that liabilities
are present obligations resulting
from past transactions or events.
So in order to recognize a liability,
the transaction or event that is committing us
to transferring assets or providing services
must have happened already.
Yikes, are you still there?
I hope I haven't lost you yet.
It's important to understand what liabilities are
because they're a crucial part of normal business.
A simpler way to think of liabilities
is that they are a source of third party funding
that a business uses to buy assets
and fund operations.
If we bring that accounting equation back up,
then we can see that businesses
have two broad financing options
to choose from when buying assets.
Liabilities and equity.
Does that make sense?
I think things might become clearer
with some examples.
Let's find out.
Now that we've got a feel for what liabilities are,
let's talk through some of the common types of liability
that are worth knowing about.
To get a summary of the business's liabilities
we can take a look at its balance sheet.
A balance sheet is basically a snapshot
of a business's assets, liabilities, and equity,
at a single point in time.
In the liabilities section of the balance sheet
we list out all of our different liabilities.
Typically these categories are arranged
in order of their due date.
With the short term liabilities
at the top of the list,
and the longer term liabilities further down.
Short term liabilities, or what we accountants
like to call current liabilities,
are a business's obligations that need to be settled
within one year from now.
The most common type of liability is accounts payable.
Accounts payable relate to the bills or invoices
that we get sent when buying something
from the supplier on credit.
But why would a business want to buy something on credit?
And for that matter, what does credit even mean?
Buying something on credit
means that you're agreeing to pay later.
Or if your head works like an accountant,
you're making a present obligation
to transfer assets or provide services
to another entity in the future.
In a standard business transaction
we have two parties,
a buyer and a seller.
The seller provides the buyer with a product or a service,
along with an invoice or a bill.
And in return the buyer sends them cash
to settle the payment.
However, sellers sometimes like to incentivize buyers
to spend more money and bring their purchases forward
by offering them credit terms.
Picture a restaurant,
buying some ingredients from a food wholesaler.
One day the restaurant realizes
that they've run out of carrots,
a vital ingredient of their award winning minestrone soup.
It's Friday morning, and they're stressing out about it
because it's going to be a busy night.
And to make things worse, they're running low on cash.
Larry, the restaurant owner,
dials the local food wholesaler and says,
hey mate, look, we're badly in need of some carrots,
but the issue is, I'm a bit strapped for cash right now.
Larry, don't sweat it.
You're our best customer.
We'll have those carrots delivered to you right now.
And don't worry about the cash,
we know you're good for it.
We'll add 30 day credit terms to your invoice.
You legend, I knew I could count on you.
The seller, despite the risk of reduced cash flow,
has offered Larry one month credit terms.
Which they note down in the invoice.
This suits Larry well
because he likes to buy things on credit.
Having a one month grace period
gives him flexibility to manage his cash flow.
(cracking)
Did you hear that?
The countdown starts when they receive the invoice
and in 30 days they made the payment.
Transaction complete.
From an accounting point of view,
when the buyer receives the invoice from the supplier,
they recognize an accounts payable balance
for the amount that they owe.
And on the other side of the transaction,
the seller recognizes an equal and opposite
accounts receivable balance for the same amount.
One person's accounts payable
is another's accounts receivable.
Another kind of current liability is salaries payable.
Most businesses employ staff
that they need to pay.
Obviously.
When does that payment usually happen?
Well it depends, but often it's at the end of the month.
So when the books are prepared at the end of the month,
we need to recognize a balance for salaries payable.
Businesses also have to pay tax
on the profits they generate.
So they need to recognize taxes payable
on their balance sheet as well.
Next there's interest payable.
So you might have noticed by now
that most current liabilities include the word payable,
which makes them easy to identify.
But that's not always the case.
Accruals, or accrued expenses,
are adjusting journal entries.
Typically posted by accountants at month end
to recognize expenses that have been incurred
but haven't been recognized yet in the books.
Let's refer back to Larry.
The restaurant is fast approaching month end,
so Larry gives his accountant a call.
Hey buddy, would you mind getting our books up to date.
I'd like to check our performance for this month.
Of course.
Are there any accruals that I need to post?
Hm, yeah, we had a plumber in last week
to fix the dishwasher.
And I don't think they've sent us an invoice yet.
Ah, right you are.
What did they quote?
He didn't say, but last time it was $500 for a similar job.
In this situation, the restaurant has incurred an expense
during the current month because the plumber
has provided them with a service.
However, they haven't received an invoice,
the liability and the expense
haven't been recorded in the books yet.
So Larry's accountant posts an accrual in the books
to recognize an accrued liability
and an expense of $500.
This is an estimate because there's no supporting invoice
to match the transaction to.
But by recording this transaction,
Larry's accountant is ensuring
that the business's income statement
and balance sheet will give an accurate picture
of the restaurant's financial performance
when Larry comes to review it.
Accruals are probably worthy of a whole video by themselves.
If you'd like to hear more about them,
let me know in the comments below.
Geez, we've got a lot of current liabilities here.
And that isn't even all of them.
Two other big ones that I haven't even mentioned yet
are unearned revenue and short-term loans.
You can think of unearned revenue
as the opposite of a prepayment.
They come up when someone pays you
for a good or service in advance.
Now that might sound like an asset,
and you're right, cash is an asset.
But we're double entry bookkeeping,
so there's another side to the transaction.
In this case, it's unearned revenue,
which is a liability because you have an obligation
to transfer assets or provide a service in the future.
Short-term loans are exactly what it says on the tin.
They are loans that need to be settled
within one year from today.
But short-term loans can also refer
to the current portion of long-term loans,
which are non-current liabilities.
Non-current liabilities are obligations
that aren't expected to be settled within a year.
There are many types of non-current liability.
I'm gonna mention a few now,
but I'm not gonna get into the nitty gritty
because this video could go on all day.
And who's got time for that?
When a business wants to raise money
from outside to fund its operations
or invest in new assets, it has a couple of options.
It could seek a long-term loan from a bank
or financial institution, who in return will expect
to be repaid with interest.
Alternatively,
the business could choose to issue bonds instead.
Bonds are similar to loans,
but the key difference is that the money
is raised directly from the public.
You can think of them as formal IOU notes.
You'll still be charged interest,
although it may be cheaper than getting a loan from a bank.
The flip side however is that bonds are less flexible.
Other non-current liabilities
that I think we've all heard of
are mortgages on properties and employee pensions.
And a lesser known one is deferred income tax,
which is definitely for another day.
But you can think of it as a byproduct
of the timing differences
between your accounting and taxable profits.
That wraps up current and non-current liabilities.
But I mentioned earlier that there's a third category,
contingent liabilities.
These are less common than the other two,
but nevertheless it's worth being aware of them.
A contingent liability is a potential obligation
that may arise depending on the outcome
of an uncertain future event.
It could be risky to ignore contingent liabilities
because the outcomes can be serious.
Let me explain.
Our favorite restaurant owner, Larry,
has a problem.
One of his customers slipped and fell in the restaurant
and broke their wrist.
They're suing the restaurant for damages
because there was no wet floor sign.
If the outcome of the litigation is probable
and could be reasonably estimated,
then the contingent liability
should be recorded as a loss on the income statement
and a liability on the balance sheet.
However, if the outcome is only considered to be possible,
or remote, then the liability might only need
to be noted in the footnotes
of the restaurant's financial statements,
or not even disclosed at all.
Management need to make a judgment
or whether the outcome is going to br probable,
possible, or remote.
And that decision will influence
the accounting treatment of the contingent liability.
Thanks for watching.
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As always let me know down in the comments below
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Next week we'll take on the third pilar
of the accounting equation, equity.
So stay tuned for that.
And see you next time.
(smooth music)