A liability is an obligation payable by a business to either internal (e.g. owner) or an external party (e.g. lenders).
Owner or internal mean investment by shareholders or owner. Because business and owners are two different persons in business. if owner paid or invest in business then it’s obligation of business to return that money to owner.
There are mainly four types of liabilities in a business; current liabilities, non-current liabilities, contingent liabilities & capital.
A liability may be part of a past transaction done by the firm, e.g. purchase of a fixed asset or current asset. The settlement of liability is expected to result in an outflow of funds from the business.
In totality, total liabilities are always equal to the total assets.
(Capital + Liabilities) = Assets | So, Liabilities = Assets – Capital
Types of Liabilities
1. Current Liabilities – Obligations which are payable within 12 months or within the operating cycle of a business are known as current liabilities. They are short-term liabilities usually arisen out of business activities. Examples of current liabilities are trade creditors, bills payable, outstanding expenses, bank overdraft etc.
2. Non-current or Fixed Liabilities – Second among types of liabilities is non-current or fixed liabilities; they are long-term obligations of a business and are not payable within a year or an accounting period. They are generally used for the purchase of fixed assets. For example, long-term loans, bonds payable, debentures, etc.
3. Contingent liabilities – are those liabilities that may or may not be incurred by a business depending on the outcome of a future occurrence. In case the occurrence does not happen, an organization is not liable to pay anything. They are required to be disclosed as soon the amount can be estimated and are shown as a footnote to the balance sheet. Examples of contingent liabilities are;
Product warranty claims
Guarantee for loans
4. Owner’s funds/Capital/Equity – Last among types of liabilities is the amount owed to proprietors as capital, it is also called as owner’s equity or equity. Capital, as depicted in the accounting equation, is calculated as Assets – Liabilities of a business. It is an internal liability of the business and includes reserves and profits.