What Are Business Liabilities? Types, Examples and FAQs
By Indeed Editorial Team
Updated July 29, 2021 | Published February 4, 2020
Updated July 29, 2021
Published February 4, 2020
Businesses track their financial transactions, assets and debts to determine past, present and future financial status. While assets may provide future economic benefit, liabilities can decrease a company’s value and equity. In this article, we explore the importance of liabilities and the role they play and share examples of liabilities.
What is a liability?
In simple accounting terms, a liability is debt that your company owes others. They should not be confused with 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. Liabilities are usually settled by providing payments, products or services. Assets, or what your company owns or is owed, should always outweigh its liabilities. If not, your company may be in financial trouble.
Liabilities are listed on a company’s balance sheet to give shareholders a snapshot of the company’s financial health. Common examples of company liabilities include:
Money owed to suppliers
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.
Related: Learn How To Calculate Liabilities
Types of liabilities
As capital flows in and out of business, liabilities are recorded and paid. Liabilities can be classified in two ways:
Noncurrent liabilities, also called “long-term liabilities,” are money owed to another party that isn’t due in full for 12 months. They are typically loans, pensions, mortgages or similar items.
Examples of noncurrent liabilities include:
Contingent liability as a result of special circumstances
Retirement benefit payments
Current liabilities, also called “short-term liabilities,” are typically paid off or settled within a year. They are 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: Your Guide To Current Liabilities
Liability examples and definitions
The following are some most 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 for. Invoices come from suppliers, vendors or other businesses for goods or services rendered.
On the balance sheet, accounts payable shows up as the sum of all amounts owed. Increases or decreases to accounts payable from previous accounting periods are reflected in the cash flow statement to shareholders.
Accrued liabilities occur when a business encounters an expense it has yet to be invoiced for. They can be classified as either short- or long-term liabilities. Although no funds have been exchanged, the entry is made to have a record of the expense in the accounting period in which it occurred. Accounting software will generate an automated reversing entry to cancel out the accrual when the invoice is received. A purchase order is commonly used to derive the amount of the accrual.
Examples of accrued liabilities:
Compensation owed to employees
Pension plan benefits
Bank account overdrafts
Overdrafts are small advances made by a bank so that a business's transactions are not declined. This occurs when the amount present in an account falls below zero. An overdraft is a current liability. Because it is considered a short-term loan, it's not uncommon for businesses to treat it as positive cash flow until it's paid 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 services, goods or products are not provided, the company is obligated to return the funds.
Dividends are money paid to the shareholders of an organization. As profits are allocated, dividends are paid to investors by the percentage of stock they own in the company. Until the funds are distributed, a dividends payable account is opened as a current liability.
Employee income tax withheld
Organizations that have employees are legally obligated 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 U.S., the types of taxes withheld are:
Federal income taxes
State income taxes (depends on the 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 IRS. Taxes can be paid 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 is made up of three parts that are classified differently in the financial statements:
Principle to be paid within 12 months
Remaining principal of the loan
The interest of the loan is considered an expense and is recorded on the income statement. The principle of the loan to be paid within 12 months is considered a current liability. The rest of the loan principal is considered a noncurrent, long-term liability. Mortgages paid on the required day of the month are usually considered an expense for that month.
A potential lawsuit is an example of a contingent liability. Pending lawsuits are typically recorded as a footnote on financial statements. To be recognized, it must meet 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 products will be returned. Companies issue warranties to customers but customers rarely collect on them. The business records an estimated amount as an increase (debit) to warranty expense and as an increase (credit) to contingent liabilities. At the end of the accounting period, the accounts are adjusted to reflect the true amount of honored warrantees.
Salaries payable is a current liability account of the amount owed to employees at the next payroll cycle. In other words, it is the amount owed to employees that they haven't been paid yet. This total is reflected on the balance sheet and increased with a credit entry and decreased with a debit entry.
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 while a payable account is only the amount that is owed at the end of the period.
Unearned revenue is an example of a current liability where services are owed instead of money. The revenue is an advance of funds contingent on the exchange of future goods or services. After the agreement is fulfilled, an offsetting entry is made and the liability is recognized 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
Frequently asked questions about business liability
Here are some common questions regarding business liability:
How do liabilities relate to assets and equity?
Assets are what the company owns or is owed. Liabilities are what the company owes others. Equity is the remaining amount, or net worth, after assets have been totaled and liabilities subtracted from the balance. If a company takes on more liability, or debt, without adding more assets, its equity value will drop. The accounting equation is: Assets - liabilities = equity.
What is the formula for current liabilities?
Current liabilities represent debts that a business must repay within one year or the time it takes a business to buy inventory and convert it into sales. To calculate current liabilities, you need to 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 are generally rare and unexpected. Lawsuits, real or threatened, are the most common contingent liability. In some cases, contingent liabilities are recorded 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. Contingent liabilities must be listed on a company’s balance sheet if they are probable and the amount can be estimated.
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 are usually recurring, monthly expenditures. Liabilities are a reflection of what is owed in the future.
Some examples of expenses are:
Costs of goods sold (COGS)
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