What is a liability?

A LIABILITY is an obligation on the part of one human or corporate entity to transfer assets or other economic benefits to another human or corporate entity at some time in the future. This transfer of assets is most often in the form of cash but does not have to be.

A typical situation is that entity A borrows money from entity B. Entity A now has an obligation to pay the money back to Entity B according to terms agreed by both parties. Therefore Entity A has a liability arising from this agreement to borrow money, and they must discharge this obligation by transferring assets (cash) at agreed intervals until all conditions of the agreement have been met.

There are two general classifications of liability:

These are Liabilities that are expected to be discharged within one year. Such Liabilities arise commonly as a result of day to day business trading. A business buys goods on credit and settles the bill at the end of the month. This type of Liability is called "Accounts Payable" and normally accounts payable are settled in 30-60 days (much less than one year). Another typical Current Liability is wages and salaries of business employees. In this circumstance, there will always be some hours worked by employees for which the business is obligated to pay in the very near future. Another typical Current Liability is unpaid tax, that is tax the business has accrued but not yet paid.

The are liabilities that are NOT expected to be discharged within one year. Long-term liabilities include Bank Loans, Mortgages, Debentures, Long Service Leave entitlements, Leases and Bonds. The case of a Bank Loan is easiest to understand. If Entity A borrows money from a bank and the terms of the agreement are that Entity A must make monthly repayments for 5 years (60 consecutive months), then the amount owing to the bank will be a long-term liability for the first 4 years. As the loan moves into its 5th year, the liability will, strictly speaking, become a Current Liability because now there is less than one year until the loan is fully discharged.

For students of accounting, it is important to know that Liabilities, current or long-term, are a balance sheet item always.

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