Ordinarily, liabilities are obligations a person owes to another person. In personal finance, a liability is a debt a person owes another person, a bank, or an organization. The focus here, however, is Liabilities in a business.
Meaning of liabilities
According to the International Financial Reporting Standard (IFRS) Conceptual Framework “liability is a present obligation of an entity transfer economic resource as a result of past events.”
Liability can also be defined as an obligation a business must pay to another party or parties.
From the definitions, you will notice that liability is an obligation. This means that the entity has a responsibility or duty to another party. The obligation can either be a bank loan, goods purchased on credit basis, obligation to pay taxes among others.
The obligation must be in the present. It is expected that the business will pay part of the obligation or all of it now. If the obligation is passed, then it is no longer a liability. For example, in a loan agreement
The obligation to pay loans between 2016 and 2018. If the firm successfully pays up such loan within the two years, then the obligation has passed.
The obligation exists from the past event. The event may have occurred in the earlier hours of the day or for the past years. Purchase of goods on credit yesterday is a past event. In addition, a loan undertaking in 2017 is a past event.
The entity must transfer its economic resource to another party to settle the obligation. The economic resources might be in cash, convertible securities (that is, converting a loan or a bond to equity), investment or the firm’s tangible assets such as a land and building.
Finally, the economic resource is transferred to another party. This party is external to the business. Examples of such parties are creditors, banks and tax authority.
Liability is one of the important sources of financing a business. If a business needs to meet up a project but have insufficient fund, it might decide to borrow the money from a financial institution and institution back the money in piecemeal.
In the next article, assets will be explained.