Liability account definition

These debts usually arise from business transactions like purchases of goods and services. For example, a business looking to purchase a building will usually take out a mortgage from a bank in order to afford the purchase. The business then owes the bank for the mortgage and contracted interest. In a sense, a liability is a creditor’s claim on a company’ assets. In other words, the creditor has the right to confiscate assets from a company if the company doesn’t pay it debts.

If the debit is larger than the credit, the resultant difference is a debit, and this is listed as a numerical figure. If the credit is larger than the debit, the difference is a credit, and this is recorded as a negative number or, in accounting style, a number enclosed in parenthesis, as for example (500). Thus, if the entry under the balance column is 1,200, this reflects a debit balance. As mentioned, normal balances can either be credit or debit balances, depending on the account type. In general, a liability is an obligation between one party and another not yet completed or paid for. Current liabilities are usually considered short-term (expected to be concluded in 12 months or less) and non-current liabilities are long-term (12 months or greater).

  • Once the utilities are used, the company owes the utility company.
  • Contra asset accounts are recorded with a credit balance that decreases the balance of an asset.
  • The expenses can be tied back to specific products or revenue-generating activities of the business.
  • It provides a way to categorize all of the financial transactions that a company conducted during a specific accounting period.

Setting up a chart of accounts can provide a helpful tool that enables a company’s management to easily record transactions, prepare financial statements, and review revenues and expenses in detail. Liability accounts are important because they show how much debt a company has. When a company deposits cash with a bank, the bank records a liability on its balance sheet, representing the obligation to repay the depositor, usually on demand.

In other words, the contra liability account is used to adjust the book value of an asset or liability. Recorded on the right side of the balance sheet, liabilities include loans, accounts payable, mortgages, deferred revenues, bonds, warranties, and accrued expenses. In a general ledger, or any other accounting journal, one always sees columns marked “debit” and “credit.” The debit column is always to the left of the credit column. Next to the debit and credit columns is usually a “balance” column. Under this column, the difference between the debit and the credit is recorded.

Liabilities are legally binding obligations that are payable to another person or entity. Settlement of a liability can be accomplished through the transfer of money, goods, or services. A liability is increased in the accounting records with a credit and decreased with a debit. A liability can be considered a source of funds, since an amount owed to a third party is essentially borrowed cash that can then be used to support the asset base of a business.

What is a Liability Account? – Definition

For ordinary negligence, an auditor owes a duty only to their client. An auditor’s liability for general negligence in the conduct of an audit of its client’s financial statements is confined to the client. That being the person or business entity who contracts for or engages the audit services. In the above example, the debit to the contra liability account of $100 lets the company recognize that the bond was sold at a discount. Note that accountants use contra accounts rather than reduce the value of the original account directly to keep financial accounting records clean. Also sometimes called “non-current liabilities,” these are any obligations, payables, loans and any other liabilities that are due more than 12 months from now.

In this case, the bank is debiting an asset and crediting a liability, which means that both increase. A contingent liability is an obligation that might have to be paid in the future, but there are still unresolved matters that make it only a possibility and not a certainty. Lawsuits and the threat of lawsuits are the most common contingent liabilities, but unused gift cards, product warranties, and recalls also fit into this category. As a practical example of understanding a firm’s liabilities, let’s look at a historical example using AT&T’s (T) 2020 balance sheet. The current/short-term liabilities are separated from long-term/non-current liabilities on the balance sheet. If you borrow money from a bank and deposit it in your Checking Account, you increase or credit a Liability account, Bank Loan Payable, and increase or debit an Asset account, Checking Account.

Accounts Payable

Most state laws also allow creditors the ability to force debtors to sell assets in order to raise enough cash to pay off their debts. A provision is a liability or reduction in the value of an asset that an entity elects to recognize now, before it has exact information about the amount involved. For example, an entity routinely records provisions for bad debts, sales allowances, and inventory obsolescence. Less common provisions are for severance payments, asset impairments, and reorganization costs. However, if one company’s debt is mostly short-term debt, it might run into cash flow issues if not enough revenue is generated to meet its obligations.

Different types of liabilities are listed under each category, in order from shortest to longest term. Accounts payable would be a line item under current liabilities while a mortgage payable would be listed under long-term liabilities. There are also cases where there is a possibility that a business may have a liability. You should record a contingent liability if it is probable that a loss will occur, and you can reasonably estimate the amount of the loss. If a contingent liability is only possible, or if the amount cannot be estimated, then it is (at most) only noted in the disclosures that accompany the financial statements. Examples of contingent liabilities are the outcome of a lawsuit, a government investigation, or the threat of expropriation.

How debits and credits work for different accounts

Simultaneously, in accordance with the double-entry principle, the bank records the cash, itself, as an asset. The company, on the other hand, upon depositing the cash with the bank, records a decrease in its cash and a corresponding increase in its bank deposits (an asset). Long-term liabilities, also known as non-current liabilities, are financial obligations that will be paid back over more than a year, such as mortgages and business loans. AT&T clearly defines its bank debt that is maturing in less than one year under current liabilities.

Long-Term Liabilities

These debts typically become due within one year and are paid from company revenues. There are four key types of contra accounts—contra asset, contra liability, contra equity, and contra revenue. Contra asset accounts include allowance for doubtful accounts and the accumulated depreciation. Contra asset accounts are recorded with a credit balance that decreases the balance of an asset. In finance, a contra liability account is one that is debited for the explicit purpose of offsetting a credit to another liability account. Contra liabilities reduce liability accounts and carry a debit balance.

It tells you when you’ve made a mistake in your accounting, and helps you keep track of all your assets, liabilities and equity. The dividends declared by a company’s board of directors that have yet to be paid out to shareholders get recorded as current liabilities. An accountant who is negligible in their examination of a company can face what are the formulas of cos legal charges from either the company, investors, or creditors that rely on the accountant’s work. The accountant could also be responsible for the financial losses incurred from any incorrect representation of a company’s books. This possible negative scenario often leads to accountants taking out professional liability insurance.

Definition of Liability Account

The numbering system of the owner’s equity account for a large company can continue from the liability accounts and start from 3000 to 3999. Some items can be classified in both categories, such as a loan that’s to be paid back over 2 years. The money owed for the first year is listed under current liabilities, and the rest of the balance owing becomes a long-term liability.

An accountant is liable for a client’s accounting misstatements. This risk of being responsible for fraud or misstatement forces accountants to be knowledgeable and employ all applicable accounting standards. No one likes debt, but it’s an unavoidable part of running a small business. Accountants call the debts you record in your books “liabilities,” and knowing how to find and record them is an important part of bookkeeping and accounting.