Knowing what a liability is and how it functions in the accounting process is necessary to properly manage the financials of any business.
“Too often business owners fail to take the time to review their liabilities,” says Roger Knecht, President of Universal Accounting Center, which offers small business accounting training. “There are opportunities to limit the risk and liabilities in business with just a little time and attention”
So, what are liabilities?
It’s actually very simple. A liability is a debt or something owed to other people or organizations. You can turn this around and say that a liability is a claim against your business from these other people or organizations. This is how accountants often refer to liabilities.
The other type of claim on a typical business comes from you (and/or your shareholders) as equity within the business. Putting this and liabilities together into a simple equation forms the basis for accounting practices and procedures:
- Assets = Liabilities + Owner/Shareholder Equity
With a little math we can switch this around to highlight the role and importance of liabilities:
- Liabilities = Assets – Owner/Shareholder Equity
As mentioned, a liability is anything your company owes, and typically this is money. Owing money to somebody or something is considered undesirable in our personal lives, although perhaps unavoidable. But every business has at least a handful of liabilities on an ongoing basis. It’s a normal part of how things work and it’d be almost impossible for a business to exist without them.
Examples of liabilities
“Organizing the liabilities in business helps them become manageable,” continues Knecht. “You’ll be amazed the insights that will come as you look at them accordingly. There is a difference between “must haves” and “wants.”
Examples of liabilities might include:
- Employee wages and benefits
- Accounts payable (e.g. buying stock with a 30-day payment term)
- Debts accrued through the regular business operation
Understanding the different types of liabilities in accounting is essential for smart business management. There are two main categories:
- Short-term liabilities: Also called “current liabilities,” these are the monetary obligations of your business that are expected to be paid off soon – and at most within the normal cycle of a business, such as one year. Things like payroll, utilities and any short-term debt are considered short-term liabilities. Short-term liabilities will probably account for the largest share of your overall liabilities.
- Long-term liabilities: Also called “non-current liabilities,” this serves as a catch-all for everything else. It, therefore, includes liabilities not intended to be paid off in the short-term. Long-term liabilities often relate to fixed assets, such as purchases to grow your business. Things like mortgages are considered long-term liabilities.
Knecht explains: “It’s important for companies to first separate which liabilities are due or expected to be paid-in-full within the fiscal year of the business vs. those that will be paid-in-full years from now. Prioritizing which liabilities to pay down first is important but this is the first step, knowing which each is.”
Having the right accounting tools at your disposal can help you stay on top of your liability commitments. You won’t need to spend time performing administrative tasks like reconciling your bank statements; match every transaction and commitment automatically so you can spend more time growing your business.
Because a liability is always something owed, it is always considered payable to some entity. Liabilities in accounting are generally expressed as a “payable” alongside various qualifying terms.
Common short-term liabilities examples include:
- Accounts payable: Debts owed to suppliers of goods or services
- Income taxes payable: Income taxes owed to the government
- Payroll taxes payable: Taxes owed specifically on the wages of employees
- Sales taxes payable: Taxes paid by customers which the company then owes to the relevant taxing authority
- Wages payable: Debts owed to employees for their work
Common long-term liabilities examples include
- Bonds payable – typically issued to finance large-scale projects and set to fully mature and be paid in a number of years
- Accrued expenses – if expected to be settled in excess of one year
- Deferred taxes – if expected to be settled in excess of one year
- Loan payments – owed to the creditor of a major asset purchased, like machinery
- Mortgage payments – owed to the creditor of property purchased
Keep in mind: the categorization of liabilities as short or long term depends on how quickly the debt is paid off. For example, a large loan or mortgage overall is typically considered a long-term liability since it may stretch for a number of years. However, the monthly payments due on such a loan are considered short-term liabilities.
Liabilities vs. expenses
It’s important to understand the differences between liabilities and expenses from an accounting perspective. Unfortunately, it can get confusing since—on the surface—liabilities and expenses are both associated with spending.
“An expense is something consumed,” explains Knecht. “A liability is something owed regardless if it has been used or not.”
In other words, the key is in determining what you are paying for and what purpose it serves.
- Expenses: These are your company’s costs of operation—that is, the costs incurred through revenue production in the everyday running of the business. In other words, expenses serve to generate revenue. Because they’re tied to revenue generation, their metrics are used to determine net income. Therefore, they appear on the income statement where they’re displayed against revenue.
- Liabilities: The money you owe for the purchase of assets—tangible things you will own when the liability is settled. In other words, liabilities serve to gain assets. Because they’re tied to assets, and their metrics are used to determine equity, they appear on the balance sheet.
Here’s an example. If you purchase a company car with a loan, that is considered a liability. Though you may use the car to travel to sales calls and generate revenue, you will ultimately own the car—the car will become an asset. But if you decided to lease that same car, it typically will be considered an expense. Its ultimate purpose would be to generate revenue. Upon the lease completion, you will not own the car—you won’t have gained an asset. (There are some important caveats relating to the type of lease used but for our purposes this example holds true.)
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