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.
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.
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.
Types of liabilities
As capital flows in and out of a business, accountants record liabilities. Here are two classifications of 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:
Contingent liability as a result of special circumstances
Retirement benefit payments
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
Examples of liabilities
The following are some common business-related liabilities:
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 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
Pension plan benefits
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.
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 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
State income taxes, which differ by state
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.
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:
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.
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.
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 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 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
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
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.
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.
What is the difference between a liability and an expense?
Though they both reflect an organization's cash outflow, expenses and liabilities have key differences. Expenses are reductions to income and liabilities are reductions to assets. Expenses are costs incurred to keep the business functioning daily. They're usually recurring monthly expenditures. Liabilities are a reflection of owed debts in the future.
Some examples of expenses are:
Costs of goods sold (COGS)
Why are liabilities important?
Liabilities represent an important aspect of supply and demand in the economy. Producers supply products and the consumer enters into a liability agreement to pay for the products. This leads to an open flow of money and a continuous cycle of revenue. For example, a local farm sells produce to a restaurant. It invoices the restaurant for the amount owed. The money owed is a liability for the restaurant. For the farmer, the money owed is an asset.
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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