What is a Liability?
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What is a Liability?
In simple terms, a liability is something that a business or individual owes or is in debt for. For something to be considered a liability, it must meet four key elements. Number one, present. The obligation needs to exist at the reporting date of the financial statements. Number two is that the entity has an obligation. In other words, the entity is the one responsible for paying and settling obligation or debt and they cannot pass it off to someone else. Number three is that it is a result of a past event. So the obligation must have arisen from a past transaction or event such as borrowing money, receiving goods or services on credit or signing a contract. And number four, the potential of an economic outflow. This means that settling the liability will require the entity to give up resources which is usually cash, an increase in cash outflows, but could also be an outflow in goods or services. So let's go back to our friend Redd who runs a delivery company. Suppose Redd's company took out a bank loan to buy a second delivery van to help expand the business. The bank loan is a liability because; firstly it is a present obligation as the company owes money to the bank and is still outstanding at the reporting date of the financial statements. Secondly, it is owed by Redd's company who is ultimately responsible for repaying the loan back to the bank. Thirdly, the obligation arose from a past event when the company took out the loan and received the money from the bank. And fourth and finally is that it has the potential for future economic outflows as the company will need to repay the bank loan along with any interest charged.
