Teaching liabilities

Paul Jennings gives some useful tips and sequences for teaching liabilities.

The elements of financial statements are the building blocks of financial statements.  If your students understand what the elements are then they will understand the basis for reporting events in financial statements. Those elements – assets, liabilities, equity, income and expenses – are key to understanding financial reporting.

Assets are a good place to start and Accounting Cafe has some tips for teaching assets. On the other side of the balance sheet are liabilities. If assets are the resources of an entity, then liabilities are its obligations: liabilities are claims against the entity which will be settled from its resources. 

This post is just about liabilities, so for the moment we are not dealing with the tricky question of whether equity is an obligation. That will be in a later post. 

Here are some suggestions for teaching the nature of liabilities.

Duality

You can use the underlying duality of accounting to illustrate what a liability is and how it is represented in a set of accounts. When we take out a loan from a bank we see two changes in our financial position. We have cash that we did not have before and we also have an obligation to repay the bank. In accounting we identify separately the two results of this contract: the liability (the obligation to repay the loan) and the asset (the cash that we can spend).

My loss is your gain

At a conceptual level, my liability is your asset. If I have an obligation to you, then you have rights you can enforce against me. My promise to repay you the money that you lent me is mirrored by your right to collect that money from me. Notice here that I have an obligation to repay you, not just an intention, and you have a right rather than just a hope. 

Of course things aren’t quite so symmetrical once we get to the reality of different entities recognising and measuring assets and liabilities at different values but the idea is valid as a starting point.  There are always two parties to a transaction – buyer and seller – otherwise there is no transaction. So it can help to think of assets and liabilities as mirror images of each other. 

The definitions in the conceptual framework support this.¹

Some liabilities are financial, others aren’t

I introduce the idea of liabilities in class by talking about cash and loans, because that is an obvious place to start and because everyone understands the basic idea behind borrowing and repaying money. But not all liabilities are financial.  Every liability that’s recognised in our financial statements will have a number next to it – but the numbers are just a way of keeping score.

As well as obligations to pay cash to someone (described as loans, payables, etc) we also have obligations to do things, for example to provide goods or services to our customers. For many sales, the agreement to transact, the payment from the customer to us and the transfer of goods from us to the customer all happen at the same time. But if there is a delay between when we enter the contract and when we do the work, then there is an outstanding promise and that is represented by a liability in our financial statements. Such liabilities are often described as performance obligations (because we have the obligation to perform – to give our customer what we have agreed). 

For example, an airline (let’s call them Icarus Airways) sells tickets to customers in advance of the date of travel. From the point where the customer has paid, and has the right to take the flight (the customer’s asset), the airline will recognise an obligation to transport the customer (the airline’s liability). The liability might be described as ‘unused flight coupons’² or something similar in the financial statements.

Then, on the day of travel, Icarus Airways flies the customer from, say, Crete to Sicily, and in doing so discharges its obligation.

Liabilities and other elements

This example also nicely illustrates income (in this case sales revenue) which is explored in more detail in the post about the nature of income. Actually I come back to this example when teaching revenue because it drives home the point that, in the language of the Conceptual Framework, income is recognised as the liability reduces. In fact performance obligations like this are sometimes labelled ‘deferred revenue’³ in the statement of financial position because they will result in revenue in a future accounting period. 

Also, Icarus Airways has almost certainly leased its planes rather than buying them outright. Which allows us to neatly bring this back to duality: the contract which we might call a ‘plane lease’ refers to the plane (the asset) and the lease (the liability to make payments in return for using the plane). 

Understanding liabilities is key to understanding financial statements so it is worth getting your students to work with the definitions and develop a conceptual understanding of the elements of financial statements.

© AccountingCafe.org

[1] Conceptual Framework paras 4.3 and 4.26.

[2] This is the term used by Lufthsana.

[3] This is the term used by International Airlines Group.