What Is a Liability? (Plus Types, Examples and FAQs)

Updated October 10, 2022

Effective accounting is a vital element of operating a business successfully. By monitoring liabilities, assets and other financial considerations, business leaders can ensure fiscal stability. If you want to excel in finance, accounting or a related field, you may benefit from learning about liabilities and how they relate to effective business practices.

In this article, we define liabilities, discuss types and examples and answer frequently asked questions about the topic.

Key takeaways:

  • A liability is an amount of money or resources that an entity owes a different entity.

  • Some examples of liabilities include accounts payable, accrued liabilities and bank account overdrafts.

  • The opposite of liabilities are assets, which are amounts of money or resources that an entity is waiting to receive.

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What is a liability?

In simple accounting or business terms, a liability is a debt that a company owes others. This is different from a legal liability, which makes a business owner responsible for injuries or losses they inflict on others. Companies use liability accounts to maintain a record of unpaid balances to vendors, customers or employees. You can settle liabilities by providing payments, products or services. 

It's important that a company's assets, which is the money a company owns or others owe to it, outweigh its liabilities. If this is the case, the company can maintain a stable financial position. Accountants list liabilities on a company's balance sheet to give shareholders an idea of the company's fiscal health. 

Related: What Is the Definition of Liability in Accounting?

Types of liabilities

As capital flows in and out of a business, accountants record liabilities. Here are two classifications of liabilities:

Noncurrent liabilities

Noncurrent liabilities, also called long-term liabilities, are amounts of money owed to another party that aren't due in full for 12 months. They're typically loans, pensions, mortgages or similar items. Examples of noncurrent liabilities include:

  • Deferred credits

  • Contingent liability as a result of special circumstances

  • Retirement benefit payments

Related: How To Use Long-Term Liabilities (With Examples)

Current liabilities

An entity pays off or settles current liabilities, also called short-term liabilities, within a year. They're the most common type of business liability. Examples of current liabilities include:

  • Wages owed to employees

  • Interest payments for short-term credit purchases

  • Dividend payments to shareholder

Related: Guide to Current Liabilities: Definition and Examples

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Examples of liabilities

The following are some common business-related liabilities:

Accounts payable

Accounts payable is a section of a company's general ledger that reflects the amount the business owes but has not yet paid off. Invoices come from suppliers, vendors or other businesses for goods or services rendered. On the balance sheet, accounts payable show up as the sum of all amounts owed. Accountants reflect increases or decreases to accounts payable from previous accounting periods in the cash flow statement to shareholders.

Accrued liabilities

Accrued liabilities occur when a business encounters an expense it has yet to be invoiced. Accountants classify these as either short- or long-term liabilities. Although entities haven't exchanged funds, accountants make this entry to have a record of the expense in the accounting period in which it occurred. Accounting software generates an automated reversing entry to cancel out the accrual when the business receives an invoice. A purchase order is helpful in deriving the amount of the accrual.

Examples of accrued liabilities include:

  • Compensation owed to employees

  • Outstanding loans

  • Payroll taxes

  • Pension plan benefits

Related: What Are Accrued Liabilities? (With Definition and Examples)

Bank account overdrafts

Overdrafts are small advances made by a bank so that a business can process transactions. This occurs when the amount present in an account falls below zero. An overdraft is a current liability. Because it's a short-term loan, it's not uncommon for businesses to treat it as positive cash flow until they pay it off. This generally happens when the overdraft occurs at the end of a period.

Customer deposits

Payments made by customers in advance of receiving products or services are liabilities. If the business doesn't provide the services, goods or products, it has an obligation to return the funds. The business still owes the customer, so it's a type of liability.

Dividends payable

Dividends are amounts of money an organization pays its shareholders. As business leaders allocate profits, they pay dividends to investors by the percentage of stock owned in the company. Until they distribute the fund, they open a dividends payable account as a current liability.

Employee income tax withheld

Organizations that have employees have the legal obligation to pay taxes to the federal government. Employee income tax withheld is the amount the employer owes to the government after each pay cycle. In the United States, the types of taxes withheld are:

  • Federal income taxes

  • Medicare

  • Social Security

  • State income taxes, which differ by state

  • Unemployment tax

Depending on the state, a company may have to pay additional taxes. The frequency of payroll tax payments depends on the size of the business and is determined by the Internal Revenue Service. Entities can pay taxes annually, biannually, monthly, bimonthly or weekly.

Mortgage payable

A mortgage is a loan for the ownership of an asset such as land, property or building. A mortgage loan comprises these three parts that classify differently in financial statements:

  • Interest

  • Principle to be paid within 12 months

  • Remaining principal of the loan

Accountants consider the interest of the loan as an expense and record it on the income statement. They consider the principle of the loan to be paid within 12 months as a current liability. They consider the rest of the loan principal as a noncurrent, long-term liability. Finally, they usually consider mortgages they pay on a required day as an expense for that month.

Potential lawsuits

A potential lawsuit is an example of a contingent liability. Accountants record pending lawsuits as a footnote on financial statements. To be recognized, it must meet these two conditions:

  • The amount of the payout is reasonably estimable.

  • The lawsuit is likely to occur.

Product warranty

A product warranty is another example of contingent liability because the issuing company can only estimate how many returns there might be. Companies issue warranties to customers, but customers rarely collect on these agreements. The business records an estimated amount as a debit to warranty expense and as a credit to contingent liabilities. At the end of the accounting period, accountants adjust the books to reflect the true amount of honored warranties.

Salaries payable

Salaries payable is a current liability account of the amount owed to employees in the next payroll cycle. It's the amount owed to employees that a company hasn't paid yet. Accountants reflect this total on the balance sheet. Salaries payable is different from salaries expense, which appears on the income statement. Salaries expense is the full amount paid to all salaried employees in a given period. In contrast, the payable account is only the amount owed at the end of the period.

Unearned revenue

Unearned revenue is an example of a current liability that involves services instead of money. The revenue is an advance of funds contingent on the exchange of future goods or services. After fulfilling the agreement, accountants offset the entry and recognize the liability as revenue. Examples of unearned revenue are:

  • Advanced retainer fees for legal services

  • Payments for subscriptions services

  • Prepaid insurance

  • Rent paid in advance

  • Payments for subscriptions services

Related: Learn How To Calculate Liabilities

Frequently asked questions

How do liabilities relate to assets and equity?

Assets are what a company owns or others owe to it. Liabilities are what the company owes others. Equity is the remaining amount, or net worth, after accountants total the asset and subtract liabilities from the balance. If a company takes on more liability, or debt, without adding more assets, its equity value drops. The accounting equation is as follows: 

Equity = Assets - Liabilities

Related: How the Accounting Equation Uses Equity, Liabilities and Assets

What is the formula for current liabilities?

Current liabilities represent debts that a business is responsible for repaying within one year or the time it takes a business to buy inventory and convert it into sales. To calculate current liabilities, find the sum of your short-term obligations. For example, your formula may look like this:

Current liabilities = Notes payable + Accounts payable + Short-term loans + Accrued expenses + Unearned revenue + Current portion of long-term debts + Other short-term debts

Each of those components represents a short-term monetary obligation or debt and the current liabilities calculation can vary based on what you owe.

Related: What Is the Current Liabilities Formula? (With Example)

What is a contingent liability?

Contingent liabilities arise as a result of special circumstances. They're generally rare and unexpected. Lawsuits, real or threatened, are the most common contingent liability. In some cases, accountants record contingent liabilities when the company expects a transaction, such as unused gift cards or product warranties, to occur but doesn't yet know the date or amount of the transaction. You can list these liabilities on a company's balance sheet if they're probable and it's possible to estimate the amount.

This article is for informational purposes only and does not constitute financial advice. Consult with a licensed professional for any issues you may be experiencing.

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