8. Defining a Liability

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From the course by IESE Business School

Accounting: Principles of Financial Accounting

592 оценки

IESE Business School

Accounting: Principles of Financial Accounting

592 оценки

Course 1 of 5 in the Specialization Foundations of Management

Financial Accounting is often called the language of business; it is the language that managers use to communicate the firm's financial and economic information to external parties such as shareholders and creditors. Nobody working in business can afford financial illiteracy. Whether you run your own business, work as a manager or are just starting your career, you want to understand financial information and be able to interact with accountants, controllers, and financial managers. You want to talk business! This course will provide you with the accounting language's essentials. Upon completion, you should be able to read and interpret financial statements for business diagnosis and decision-making. More importantly, you will possess the conceptual base to keep learning more sophisticated accounting and finance on your own. Do not forget that, as with any other language, becoming proficient with accounting requires constant practice.

From the lesson

Course Overview & Week 1: Introduction to Accounting - The Balance Sheet

Welcome! Before you start today's videos, please have a look at the syllabus. In this first session, I'll give you an overview of what accounting is all about and why it's important to have a basic proficiency in this "language." In addition, I'll introduce one of the most important financial reports - the balance sheet - and a practical real-world case so you can put theory into practice. Objectives: To gain insight into the essence of accounting and become familiar with the balance sheet and its purpose.

1. Accounting: The Language of Business6:17

2. Practice Case: The Campus Bookstore I7:07

3. Practice Case: The Campus Bookstore II3:09

4. Accounting for our First Transactions3:10

5. Accounting for More Transactions5:07

6. Explaining the Balance Sheet7:05

7. Defining an Asset6:04

8. Defining a Liability4:26

Meet the Instructors

Marc Badia
Assistant Professor
Accounting and Control

[MUSIC]

In the same way that they gave the precise definition of an asset,

let me now define a liability.

So the elements of a definition of liability are the following.

First is a present obligation of the firm to transfer economic benefits, meaning

cash or some sort of asset or a product or service to a third party in the future.

For example, in the case of a loan when you receive the loan,

you have the obligation to return that money.

So in the future, you have a present obligation because you

have already received the loan from the bank.

And in the future you have to repay this money to the bank.

The second element of the definition is that it arises from a past event or

transaction.

Again in the case of the loan, it's because we have already received

the loan on December 31st, in the case of the campus bookstore.

The campus bookstore has the obligation to repay it in the future.

Another example, at the moment the campus bookstore purchases the inventory,

and it doesn't pay in cash, obviously, it will have to pay in the future.

At that very moment in which it receives the inventory, it owns the inventory and

it has the obligation to pay in the future.

So the obligation to pay arises from this precise transaction.

As with assets, a necessary condition to recognize a liability is that first it

is probable that this economic benefit will flow out of the firm in the future.

So it's very probable that we will have to pay, that we have to give a service,

a product.

And second that economic benefit you have to transfer in the future can be measured

reliably.

Now, in the case that you could estimate the amount or that the probability of

these economic benefits flowing out of the firm was very low, the only thing you

would do is to disclose this in the notes to the financial statements.

But you wouldn't recognize it on the balance sheet.

With all this in mind,

tell me whether the following examples can be recognized as liabilities or not.

First, a firm like the campus bookstore gets a bank loan.

What do you think about this?

Is this a liability?

Well this particular example is easy,

because we already recognize it on our balance sheet actually.

Why? Because it's a present

obligation that we have that arises from a past transaction.

And the past transaction is that we have received the money already

on December 31st, and obviously we have to repay these at the end of the third year.

Let me give you a second example.

Let's see about the case of a lawsuit.

So it's likely that the company is going to lose a lawsuit,

because the company did something illegal.

But we don't know, we cannot estimate the amount we will have to pay.

Is this a liability?

What do you think?

Well the reality is that you know you have a present obligation,

that you have to pay something if you lose the lawsuit.

It's a result of past event,

in this case maybe something illegal that triggered this lawsuit.

But the problem is that you cannot estimate the amount, and

therefore that's a necessary condition to be able to estimate,

reliably, the amount of the liability.

It's a necessary condition to account for it.

Therefore in this case, the only thing we could do is to disclose it on

the footnotes because I'm sure that the investors would like to know this but

without saying the amount here.

Let's go for a third example.

A car maker sells cars with 3-year warranties.

Do you think this is a liability?

Well, it is a liability.

By the fact that the company is selling the car with a warranty contract, at

the very moment that it sells the car, it has the obligation to honor this warranty,

in case it was exercised in the future.

So the obligation is already there.

It's a present obligation.

We don't know the date that it's going to be exercised, but the obligation is there.

Second, the past event that has triggered it is selling the car

with the warranty contract.

Now, the only problem is that we need to estimate the amount.

But based on past experience, it's very possible that we can estimate the amount

of warranties that are normally exercised.

So most of the car makers,

they can estimate very well the amount of warranties that are exercised, and

therefore this is recognized as a liability on the balance sheet.

Actually, these kind of liabilities where you have to estimate the amount

are called provisions.

In any case, provisions is something that goes beyond the scope of this course.

[MUSIC]

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