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If you’ve ever reviewed accounting documents for your business, chances are you’ve asked yourself “What is a liability?” and wondered if you had any. When looking at your business balance sheet, you will see it divided into assets, equity, and liabilities. As a business owner, it’s critical to understand this aspect of your company’s accounting. Understanding this term and what it means for your business will help you gain a robust understanding of your company’s financial health. Read on to learn the liability definition, what qualifies as one, and the different types.
What is a Liability in Accounting?
A liability refers to something a person or company owes. This usually specifies a sum of money a business owes. This includes money owed to creditors, suppliers, employees, government agencies, and others. By definition, when liabilities exceed assets on a balance sheet of a company’s financial statements, the company has a negative net worth.
Liabilities vs expenses
Expenses consist of the costs of operating a business. They are necessary for a business to generate revenue. However, expenses decrease a business’s net worth, while liabilities have no effect on it. You can find a business’s liabilities on a business balance sheet. Conversely, you can find a business’s expenses on its income statement. Expenses explain the cost of operation, while liabilities are any obligations the business owes to another party after receiving goods or services. By definition, expenses are transactions that a business can pay off immediately with cash. However, a delay in payment turns an expense into a liability.
Liabilities vs assets
Assets consist of both tangible and intangible items. A business’s assets may consist of buildings, machinery, equipment, patents, intellectual property, accounts receivable, and any interest owed to the business. Assets are either things the business owns outright or are things that another party owes the business. Combining a business’s liabilities with its equities gives an accountant the business’s total assets.
The Types of Liabilities
A liability represents the goods, services, or currency that a company has not fully paid for yet. These may include loans, debts, and transactions that have not been settled yet. There are two kinds: Short-term and long-term.
Long-term liabilities are those that will conclude in 12 months or more. Non-current liabilities are typically long-term. While businesses usually pay for short-term liabilities with cash, they may pay for long-term ones with assets such as future earnings or financing transactions. Long-term ones typically consist of things like loans, bonds, rent, mortgage, taxes, payroll, and any employee pensions offered by the company.
Short-term liabilities refer to those that have a timeline of 12 months or less. Current liabilities are typically short-term. These typically consist of things like payroll expenses, accounts payable, and monthly utilities. Showing that a business can pay its current debts regularly and on time is vital to investors. If a business is paying back a long-term loan, then the loan itself is a long-term liability by definition. However, the payments on that loan due within the current year are short-term.
The Categories of Liabilities
When a business is liable, it means they are responsible for any money, goods, or services owed to another party. Businesses can use liabilities to finance operations, pay for expansions, and keep business-to-business transactions efficient. A business’ liabilities often include loans, accounts payable, mortgages, deferred revenues, bonds, warranties, and accrued expenses. While most are broken down by term length, some categories fall under current or non-current.
Current liabilities are short-term. These refer to any debts a business must pay within one year.
Common current examples include:
- Wages Payable: This term refers to the total amount of income that a business’s employees have earned but have yet to be paid. Most business’ pay their employees every two weeks, which means this liability definition may be constantly changing depending on how many salary vs. hourly workers a business employs.
- Dividends Payable: Larger corporations with investors must pay those investors a dividend. Dividends payable represent the amount owed to shareholders. However, they typically only show up on a business’s balance sheet every few months.
- Interest Payable: When businesses pay for things with a credit card and don’t pay the full balance each month, the payments accrue interest. Interest payable tracks the total of interest owed by the business as a current liability.
Less common current liabilities are things like unearned revenues and those of discontinued operations. Unearned revenues refer to a company’s responsibility to provide goods and/or services in the future while being paid in advance. Liabilities of discontinued operations come into play when businesses must account for the financial impact of an operation, division, or entity that they no longer have. And if a business shuts down a product line, for instance, they will record it in this section.
Non-current liabilities are long-term. This means the business owes these debts in more than one year.
Common non-current examples include:
- Bonds Payable: Long-term debt, or bonds payable, is typically a business’s largest liability. You can find this at the top of the list. Businesses finance part of their ongoing operations by issuing bonds. These are essentially loans from the bond purchasers.
- Warranties: This is the estimated amount of time and money it would cost to repair products that have a warranty agreement. If a business sells any products with warranties, then they would list this category here.
- Contingent: A contingent liability is one that depends on the outcome of an uncertain future event. An example of this would be a pending lawsuit against the business. Additionally, unused gift cards or product recalls qualify as well.
Less common non-current liabilities consist of things like deferred credits, post-employment benefits, and unamortized investment tax credits (UITC). While they may be not be as common as other types, you should not overlook them.
Depending on the timeline specifics, you may record deferred credits as non-current or current liabilities. These credits refer to revenue a business collects before recording the earnings on the income statement. Examples of this are customer advances, deferred revenue, or transactions where the business owes credit but it is not yet revenue. Once the business earns the revenue, it can reduce this line item by the amount earned. Then, it can transfer the amount to the business’s revenue stream.
Liabilities and Your Balance Sheet
The most common liabilities are accounts payable and bonds payable. Most businesses will have both of these listed on their balance sheet for both current and long-term accounting. Businesses should list each category of both long-term or noncurrent and short-term or current liabilities on their balance sheets. There may be both existing and potential liabilities by definition for a business to list.
Businesses should break down their liabilities on their balance sheet based on the timeline of their due dates. Current ones are due within one year and are typically paid for with current assets. Noncurrent are those due in more than one year and typically include any long-term debts the business has. Most businesses will record current and noncurrent liabilities in two line items on their balance sheet as an account of ongoing business operations.