Last time we covered assets; this time it's liabilities and equity (capital). Without further ado, let's begin!
Liabilities
“A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.”
There are three key points in this definition:
1. Arising from past eventsThis idea is not hard: every effect has a cause. For example, when a company buys goods from a supplier, it may use the credit transactions we discussed earlier — so once we take delivery of the supplier's goods, we take on an obligation to settle the amount later. For every liability, we can trace the reason for the debt back to a past transaction.
- Trade payables arise from purchasing goods from suppliers on credit.
2. Present obligationA present obligation means the debt already exists. For example, when we buy goods we sign a contract, which legally obliges the business to pay for them. So unless something goes wrong on the supplier's side — wrong goods delivered, or goods not as described — once the supplier has fulfilled their duty by shipping the goods to us, we must honour our promise and pay within the agreed period. Contrast this with a future obligation, which only arises when some future event occurs — that is, when specific conditions are met. For example, if a company is in a legal dispute with a customer, it may be found liable to pay compensation; but before the court rules, no judgment exists, so we can only regard this as a possible future obligation.
3. Expected to result in an outflow of resources embodying economic benefitsThis means that settling a debt reduces the company's assets — the economic value those assets could have earned in the future is handed over to the other party. For example, when a business pays a supplier what it owes, the amount paid represents the company losing control of that asset: the money can no longer be used by the company to earn income.
Here are some common items:1. Payables / CreditorsAmounts the company owes to a third party, to be repaid before a specified deadline.
- Trade payables — amounts owed for goods or services bought from suppliers and not yet paid — make up the main part of payables.
- Other payables (sundry payables) — amounts owed for other reasons, such as new furniture bought but not yet paid for — make up the rest.
2. Bank overdraftLast time we discussed bank accounts. When withdrawals exceed deposits, the account shows a negative balance — an overdraft. The negative balance reflects amounts the bank has paid on the company's behalf, meaning the business has effectively borrowed from the bank — hence a liability.
3. Loans from creditorsWhen the owner cannot inject new funds into the business, the company may consider borrowing. Common lenders include banks, relatives and friends — giving rise to liability items such as bank loans and loans from individuals.
Equity / Capital
“Residual value of assets after deduction of liabilities.”
For students just starting out in accounting, equity (capital) is often the most misunderstood element. Equity is determined chiefly by the value of the company's assets minus its liabilities. Many students think of equity as simply "how much money the boss has" — which is not entirely wrong, but a clearer concept to hold on to is net assets.
To understand equity (capital) properly, we break it down into four components:
- Equity / Capital
- Revenue
- Expenses
- Drawings
The next article continues with these items.
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