What is Liability in Accounting?
Liabilities in accounting is a company’s financial obligations, like the money a business owes its suppliers, wages payable and loans owing, which can be found on a business’ balance sheet.
In this article, we’ll cover:
What Are Liabilities in Accounting?
The definition of liability in financial accounting is a business’s financial responsibilities. A common liability for small businesses are accounts payable, or money owed to suppliers, according to Accounting Coach.
Liabilities are found on a company’s balance sheet, a common financial statement generated through financial accounting software. They are also referred to as “payables” in accounting.
All businesses have liabilities, except those who operate solely operate with cash. By operating with cash, you’d need to both pay with and accept it—either with physical cash or through your business checking account.
COMMON LIABILITIES IN SMALL BUSINESS
If you borrow instead of paying outright, you have liabilities. Paying with a credit card is considered borrowing too, unless you pay off the balance before the end of the month. And a business loan or getting a mortgage business real estate definitely count as liabilities.
Money owed to employees and sales tax that you collect from clients and need to send to the government are also liabilities common to small businesses, according to The Balance.
Sales tax only has to be collected by businesses in certain states. Rates vary, as well. The Small Business Administration has a guide to help you figure out if you need to collect sales tax, what to do if you’re an online business and how to get a sales tax permit.
IMPORTANCE OF LIABILITIES TO SMALL BUSINESS
Liabilities (money owing) isn’t necessarily bad. Some loans are acquired to purchase new assets, like tools or vehicles that help a small business operate and grow.
But too much liability can hurt a small business financially. Owners should track their debt-to-equity ratio and debt-to-asset ratios. Simply put, a business should have enough assets (items of financial value) to pay off their debt. This article provides more details and helps you calculate these ratios.
FreshBooks makes it easy to find and decode your liabilities with its cloud-based accounting software.
LIABILITIES VS. EXPENSES
A liability is money owed to buy an asset, like a loan used to purchase new office equipment. Expenses are ongoing payment for something that has no physical value or for a service, according to The Balance.
- An example of an expense would be your monthly business cell phone bill. But if you’re locked into a contract and you need to pay a cancellation fee to get out of it, this fee would be listed as a liability.
- Utilities for your store are an expense. The mortgage on your store is a liability.
Expenses are also not found on a balance sheet but in an income statement. Both are financial statements.
Here are some examples of liabilities for small businesses:
- A carpenter picks up new kitchen cabinet doors from a cabinet supplier. The supplier has a good relationship with the carpenter and let him buy on credit. The supplier gives the carpenter an invoice for the doors that he must pay within 30 days. The amount owed on these doors is a liability for the carpenter.
- A freelance social media marketer is required by her state to collect sales tax on each invoice she sends to her clients. The money sits in her business bank account. It’s still a liability because that money needs to be sent to the state at the end of the month.
- A dog walking business owner pays his ten dog walkers biweekly. It’s Monday and he has to pay $2000 in wages by Thursday. The wages he owes these employees counts as a liability.
- A copywriter buys a new laptop using her business credit card. The cost is $1000. She plans on paying off the laptop in the near future, probably within the next 3 months. The $1000 she owes to her credit card company is a liability.
- An online rare book seller decides to open up a bricks-and-mortar store. He takes out a $500,000 mortgage on a small commercial space to open the shop. The mortgage is a liability as it’s a debt to be repaid.
People also ask:
What Are the Types of Liabilities?
There are two main types of liabilities: long-term liabilities and short-term liabilities. Both types are listed on a company’s balance sheet, a financial report that shows a business’s financial health at the end of a reporting period.
Long-term liabilities are financial responsibilities that will be paid back over more than a year, such as mortgages and business loans.
Short-term liabilities are financial responsibilities that will be paid back within a year.
- Sales tax: usually payable every month or quarter
- Payroll taxes: income and employment taxes withheld from employees and paid to the government
- Loans and mortgages: payments are due every month
- Accounts payable (money you owe to suppliers)
- Salaries owing
- Wages owing
- Interest payable
- Income tax payable
- Sales tax payable
- Customer deposits or pre-payments for goods or services not provided yet
- Lawsuits payable
- Debt payable
- Contracts, such as a cell phone contract you can’t cancel without penalty
- Lease agreement
- Insurance payable
- Benefits payable
- Taxes on investments
- Accrued liabilities (like interest owing that hasn’t been billed for by the lender)
What Are the Categories of Liabilities?
Liabilities are usually reported on a company’s balance sheet by category. There are seven categories that appear on a typical balance sheet. These seven categories cover assets, equity and liabilities, according to the Houston Chronicle.
Two of the categories on a balance sheet are dedicated to liabilities:
- Current Liabilities: Also called short-term liabilities. These liabilities are due within a year. These include client deposits, interest payable, salaries and wages payable and any amount owing to suppliers.
- Long-Term Liabilities: Any financial obligation that takes more than a year to pay back, such as a business loan or mortgage. Or they are short-term liabilities that have been deferred.
A note: some items can be classified in both categories, such as a loan that’s to be paid back over two years. The money owed for the first year become a current liability and the rest of the balance owing becomes a long-term liability.
What Are Liabilities on a Balance Sheet?
Liabilities are one of three accounting categories recorded on a balance sheet—a financial report a company generates from its accounting software that gives a snapshot of its financial health.
Balance sheets record assets, equity and liabilities.
An asset is anything a company owns of financial value, such as revenue (which is recorded under accounts receivable). Assets are listed on the left of a balance sheet.
Liabilities and equity (the difference between the value of its assets and debts owing) are listed on the right.
Liabilities are divided into categories on a balance sheet: short-term (current) and long-term liabilities.
Then, different types of liabilities are listed under each each categories. Accounts payable would be a line item under current liabilities while a mortgage payable would be listed under a long-term liabilities.
Below is a simple example of a balance sheet. Since there’s only one liability, accounts payable, there’s only one category:
Here’s a more in-depth example of a balance sheet. Note that a long-term loan’s balance is separated out from the payments that need to be made on it in the current year.
For more information, this article explains in-depth how to read and use a balance sheet.