Liability Example

A liability is officially defined as:

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.

In other words, a liability is simply...

A debt of the business. 

     

YOU --------------------> OWE --------------------> BANK 

The debt will result in assets (usually cash) leaving the business in the future.The most common liability is a loan. Another common liability is calledcreditors. A creditor, also known as apayable, is any business or person (apart from the bank) that you owe. Suppliers (who you owe for products purchased on credit) would fall under creditors.When you pay a loan back, or you pay off your creditors, some of your assets (most often cash) will leave your business.

b) George realizes that he needs more money to create a really high-quality catering business. Yet he does not have any more personal funds available to invest in the business. He decides to take a loan from the bank to the value of $5,000. 

As you can see, $5,000 more cash is available. This cash was obtained by creating a liability (debt). External parties (the bank) now have a $5,000 claim to the total assets of the business. George’s Catering will have to pay back the $5,000 in the future.In our previous example the assets were funded by the owner, so assets and owners equity changed, but liabilities stayed at zero.This time the assets and liabilities changed, but not the equity. The owner’s stake in the assets of the business is unaffected (still $15,000). The owner now reallyowns only 75% of the assets ($15,000 / $20,000).

Owner’s equity is officially defined as:

...the residual interest in the assets of the enterprise after deducting all its liabilities.

The owner’s equity is simply the owner’s share of the assets of a business.

Assets can only ‘belong’ to two types of people: the first type is people outside the business you owe money to (liabilities), and the second is the owner himself(owner’s equity).

Owner’s equity, often just calledequity, represents the value of the assets that the owner can lay claim to. In other words, it's the value of all the assets after deducting the value of assets needed to pay liabilities. It is the value of the assets that the owner really owns. 

ASSETS = EQUITY + LIABILITIES

Thus the accounting equation indicates how much of the assets of a business belong to, or are owned, by whom.