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