This is the second part of a two-part series Finance 101. You can read the first part of the article titled Finance 101 (part 1) What are Assets?
In this second part of our article we would be breaking down the meaning of liability. By the end of this article, you would be able to understand:
- The definition of liability
- Types of liabilities and,
- Some examples of liabilities as they relate to your business.
Now Let's get started
What is a liability
The Oxford English dictionary defines a Liability as follows
A thing for which someone is responsible, especially an amount of money owed.
From the above definition we can infer that in the business context, a liability is anything owed by a business and of which the business has an obligation to pay back. let us now proceed to give a comprehensive definition of a liability from an accounting and finance point of view. The International Accounting Standards Board (IASB) defines liability as:
A present obligation of the entity to transfer an economic resource as a result of past events
let's pick up from where we stopped in the previous article. Remember Mrs. Pelz (Pelz Socks). Pelz is in the business of selling socks, she buys a delivery motorbike in order to make deliveries to her customers, by doing so she is able to increase her sales and generate revenue. In order to fund the acquisition of the motorbike, Pelz takes a loan of N450,000 from Next level Bank. which is expected to be paid back within a year. The N450,000 loan is a liability (because Pelz has a present obligation to pay back a certain amount every month, as a result of the purchase of the motorbike which is now in the past.
Types of Liabilities
Now that we have looked at the meaning of Liability, let us go on to see the types of Liabilities.
There are two types of Liabilities:
1. Current Liability.
2. Non-current Liability
Current liabilities are debts owed by a business which are due within the short term usually 12 months, current liabilities include
- Accrued expenses
- Bank account overdrafts - These are short term advances made by the bank for overdrafts.
- Income taxes payable - These are taxes owed to the government that have not yet been paid.
- Accounts payable - This is money owed to suppliers.
Non-current Liabilities also known as long-term liabilities are liabilities which a business has a financial obligation to, but doesn't expect to be liquidating them within 12 months. Non-current Liabilities appear in the financial statements (Statement of financial position) Examples of Non-current liabilities are
- Long term loans
- Long term Leases
- Pension Obligations
To help us understand the types of Liabilities let's continue with our story of Mr. Tops (from the part 1) Mr. Tops who runs a barber shop "Tops Cuts". Tops Cuts has cash in the bank balance of N2,000,000, this is mostly from accurate proceeds of haircuts carried out through the month. Tops Cuts is also owed a sum total of N300,000 from various clients who would normally pay at the end of the month.
Mr. Tops purchased a shop which he uses as his barbing saloon, he also purchased 5 barbing chairs and equipped the shop with some amenities such as Air conditioner, mirrors, sterilizing kits, towel racks etc. from the proceeds of the business. In order to finance the acquisition of the shop Mr. Tops took a mortgage loan from the Articulate Finance Institution, the mortgage is expected to span the life of 7 years. Mr. Tops has also incurred some obligations with regards to the pension of his staff.
The aspect of the loan which will not be paid back within the first 12 months and the pension obligations are Non-current liabilities
In this write up, we have considered what a Liability is. We have also gone on to discuss the types of Liabilities and finally we have been able to apply simple examples to help us understand the concept of Liabilities, to sum up our knowledge of assets and liabilities, we can look at these concepts from a simple mathematical equation known as the accounting equation
Which simply states that
Assets = Liabilities + Equities.
According to the International accounting standards board (IASB) Equity is the residual interest in the assets of the entity after deducting all its liabilities.
As a recap we stated that an asset is "A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity" (IASB Framework).
And liability is a present obligation of the entity to transfer an economic resource as a result of past events (IASB Framework).
It is on this note that we have come to the end of our two-part series. Do stay glued to the MSME Hub for other useful articles covering a wide range of topics which would help you in the course of your entrepreneur journey.