Liability is the synonyms of Legal responsibility or obligation to give back something. Either say it an accountability or answerability.
In day to day life when it says that we are liable for the certain thing then the word denotes that we have to give back something, either it is any service or keeping our promise.
In the accounting terminology when the word Liability is used then its only shows that the business owes something and having a legal responsibility to pay back. Liability is a balance sheet item having always credit balance.
The accounting equation of liability is –
Liability = Asset – Owner’s Equity
The known examples of Liability are shareholder’s equity, Accounts Payable, Unearned Revenues, Loans taken by the business, Salary payable, income tax payable etc.
Types of Liabilities –
There are three types of Liability –
- Long-term Liability / Non-Current Liability
- Short-term Liability / Current Liability
- Contingent Liability
Long-term Liability / Non-Current Liability –
Long-term Liability is also known as Noncurrent Liability and is due more than a year. These long-term liabilities are the source of capital or financing for the business.
Examples are – Share holder’s equity, Long-term Loans, Capital Lease, Deferred Revenue, Deferred Taxes etc.
Short term Liability / Current Liability –
Short term Liability is also known as current Liability and due within a year or ina normal accounting period.
Examples are – Accounts payable, Short-term loans, accrued expenses, interest payable, unearned revenue etc.
Contingent Liability –
Contingent Liability is the liability which may arise according to the event.
Let’s take a very common example of any court case, if the court case is not in favor then the company or individual will be liable for the sum amount ordered by the court. This kind of liability is called contingent liability. To cope up such kind of liability one need to create provision.
Another example of contingent Liability is warranties. When a company gives a warranty against any product, at that point it keeps itself liable in case there is any fault comes out in its product
Looking at the above example we can divide contingent Liability into two parts i.e. Probable contingent Liability and not probable contingent Liability. This ‘probability’ point impact the accounting treatment of Contingent Liability.
If the liability is probable and can be estimated, it will be recorded to Expense/loss side in P&L and Liability side in the Balance sheet.
But if the contingent Liability is not probable or the amount cannot figure out then it will not be recorded anywhere instead it will be provided in the notes in financial statements.