- 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. (upbeat music) Hey viewers, I'm James, and
welcome to Accounting Stuff, the channel that teaches you everything you need to know about
accounting and bookkeeping. If you'd like to learn
more about these topics then check out my Accounting
Basics playlist up here. That will start you off
with video number one. I put out new content
every week on this channel so hit the subscribe
button and ring the bell to be notified when the next video is out. 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. If you found this video useful give it a like, share it, comment, subscribe if you haven't already. As always let me know
down in the comments below if you've got any questions. Or message me directly on
Instagram at accountingstuff. 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)
