Understanding Liabilities in Accounting

Liabilities in accounting represent what your business owes, including loans, accounts payable, and other debts.

In this article, we’ll explain the different types of liabilities, how they impact your business, and ways to manage them.

This guide is also related to our articles on accounting for startups, understanding debits and credits, and how to calculate bad debt expenses for businesses.

This list includes:

• Types of liabilities in accounting
• Current vs. long-term liabilities
• Examples of liabilities in small business
• How to manage liabilities effectively

Let’s jump right in!

Liabilities, assets and equity: the basics

In accounting, your balance sheet is divided into three key sections: assets, liabilities, and equity.

Assets are everything your business owns, like cash, inventory, or equipment. Liabilities represent what your business owes—whether debts or obligations. Equity is what’s left for the owner after subtracting liabilities from assets.

The basic balance sheet equation is: Assets = Liabilities + Equity

Liabilities sit on the right side of the balance sheet, under the liabilities section. They show what the business needs to pay back. Equity also sits on the right side but comes after liabilities. Assets sit on the left, showing what the business owns.

Types of liabilities

Liabilities are divided into two main categories: current liabilities and long-term liabilities—what’s due in the short term and what’s due in the long term. Current liabilities reflect your immediate financial obligations, while long-term liabilities show the bigger debts that you’ll need to manage over time.

Current liabilities

Current liabilities are debts or obligations that your business must settle within the next 12 months. These are short-term liabilities that help you manage the day-to-day financial obligations of your business. They are typically found at the top of the liabilities section of your balance sheet.

Examples include:

Accounts payable: This is money you owe to suppliers for goods or services you’ve already received but haven’t paid for yet. For example, if you receive materials on credit, the amount you owe falls under accounts payable until you settle it.

Short-term loans: Any loan that needs to be repaid within one year is considered a short-term loan. These could be lines of credit or short-term business loans used to cover immediate expenses.

Accrued expenses: These are expenses that have been incurred but haven’t been paid yet. Examples include wages earned by employees that you haven’t paid yet or utilities that are due but not settled.

Long-term liabilities

Long-term liabilities are debts or obligations that your business will pay off over a period longer than a year. Long-term liabilities are found below current liabilities on the balance sheet and reflect your business’s future financial commitments, often involving large payments or debt that is paid off over several years.

Long-term loans: Loans that extend beyond 12 months are considered long-term liabilities. These could be business loans for equipment, real estate, or expansion projects. Each month, part of the loan payment may be categorized as a current liability, but the remainder stays a long-term liability until the debt is fully repaid.

Lease obligations: If your business has long-term leases on buildings, equipment, or vehicles, those future lease payments fall under long-term liabilities. Like loans, the portion due within the next 12 months will be categorized as a current liability, while the rest remains a long-term liability.

Specific liability accounts

Each type of liability account has its own characteristics and functions. Here’s a breakdown of the main types:

Accounts payable

As we touched on above,  accounts payable represents the amounts you owe to suppliers or vendors for goods or services you’ve received but haven’t paid for yet. This includes invoices for inventory, office supplies, and other business expenses. Accounts payable are recorded as a current liability on your balance sheet because they are typically due within a short period, usually 30 to 90 days.

For example, if you order materials from a supplier and receive an invoice, that amount becomes part of your accounts payable until you pay it. Keep track of your accounts payable to manage cash flow and avoid late fees.

Notes payable

Notes payable are written promises to pay a specific amount of money by a certain date. Unlike accounts payable, which are usually informal and short-term, notes payable often involve formal agreements and can be either short-term or long-term.

Short-term notes payable might include a promissory note for a loan from a bank with a repayment period of less than one year. Long-term notes payable generally involve a more extended loan or financing arrangement. These are recorded as liabilities on your balance sheet and can be useful for larger, planned expenses like equipment purchases or business expansion.

Accrued liabilities

Accrued liabilities are expenses your business owes that have been incurred but not yet invoiced for or paid. Accrued liabilities are recorded as current liabilities if they are expected to be settled within a year.

These might be wages earned by employees that haven’t been paid yet, interest on loans that is due but not yet paid, or utilities used but not yet billed.

Deferred revenue

Deferred revenue is money you receive before delivering goods or services. It’s essentially a liability because you owe the customer a product or service. Until you fulfill this obligation, the money received is recorded as deferred revenue on your balance sheet.

Bonds payable

Bonds payable represent long-term debt issued by your business, typically to raise large amounts of capital. When you issue bonds, you promise to pay back the bondholders the principal amount plus interest over a specified period.

Bonds payable are recorded as long-term liabilities on your balance sheet. They are used for major investments or expansions, such as building new facilities or acquiring significant assets. Payments on bonds are usually made semiannually and include both principal and interest.

Accounting for specific transactions

Here’s how to handle some common scenarios when accounting for specific transactions:

Recording liabilities from loans

When you borrow money, record the liability by recognizing the amount you owe. Start by entering the full loan amount as a liability on your balance sheet under Notes Payable or Long-Term Liabilities, depending on the loan’s term.

When you make payments, split them into principal and interest. The principal reduces the loan balance, while the interest is an expense. For example, if you take a $10,000 loan with a 5% annual interest rate, each monthly payment will consist of a portion that goes toward the principal and a portion that covers the interest expense.

Record the interest expense on your income statement, and adjust the loan balance on your balance sheet accordingly.

Accounting for lease obligations

If your lease—whether for equipment or real estate—is classified as an operating lease, record the lease payments as an expense on your income statement. Each payment is categorized under Lease Expense, and there’s no liability recorded on the balance sheet, except for any unpaid amounts.

Capital leases (also known as finance leases), are treated like a purchase, so record both the asset and the corresponding liability on your balance sheet. The liability is recorded under Lease Obligation and represents the total amount you owe over the lease term.

As you make payments, again, divide them between the principal and interest, so the principal reduces the liability and the interest is an expense.

Accrued expenses and deferred revenue

Accrued liabilities are costs that have been incurred but not yet paid. So for example, if you owe wages to employees for work done in the current period but have not yet paid them, record these as Accrued Expenses on your balance sheet.

When you pay these expenses, reduce the accrued liability account and record the cash outflow. You want to be sure your records accurately reflect the timing of these expenses to match them with the period they belong to.

Deferred revenue is money received before you provide goods or services.

Let’s say a customer pays in advance for a yearly subscription to your service: that payment is recorded as deferred revenue. As you deliver the service over time, you gradually recognize the revenue, moving it from a liability to earned revenue on your income statement.

Liabilities and business decisions

Liabilities influence your liquidity, solvency, and overall financial strategy. Here’s what that means in practical terms.

Liquidity refers to your business’s ability to meet short-term obligations. If not well managed, high levels of current liabilities, like accounts payable or short-term loans, can strain your liquidity. Keep an eye on  your cash flow to be sure you have enough liquid assets to cover these short-term debts. If your business regularly faces liquidity issues, consider adjusting payment terms with suppliers or seeking additional short-term financing.

Solvency is your ability to meet long-term obligations and remain financially stable over time. This is measured by comparing your total liabilities to your total assets. If liabilities are too high compared to assets, or are growing faster than your assets, your business may struggle with solvency and you might need to explore strategies to reduce debt or increase assets.

Strategic debt management

Start by categorizing your debt into short-term and long-term liabilities.

Short-term debt, such as lines of credit or short-term loans, should be carefully managed to avoid cash flow problems. Keep track of repayment schedules and interest rates. If possible, negotiate better terms with lenders or consider consolidating multiple short-term debts into a single, lower-interest loan.

Long-term debt involves larger amounts and longer repayment periods. Evaluate the terms of your long-term loans and bonds so the repayment schedule aligns with your business’s revenue cycles and long-term plans.

Use long-term debt to finance major investments or expansions that will generate future income. Avoid over-leveraging your business, as excessive long-term debt can strain financial resources and limit growth opportunities.

Regularly review your debt levels and repayment plans and make adjustments as needed. You want your debt to be both manageable and aligned with your business strategy.

Implications for investment and financing decisions

If you’re considering new investments, first assess how they will impact your existing liabilities and overall financial position.

Before committing to new projects or capital expenditures, evaluate how the investment will affect your debt levels. You want to make sure the expected return on investment justifies the additional liabilities. If you’re planning to buy new equipment, say, calculate the expected increase in revenue against the cost and any associated debt.

And if you’re considering additional financing, you’ll need to know how new debt will affect your current liability structure. Lenders will scrutinize your existing liabilities to assess your creditworthiness, and a balanced debt-to-equity ratio shows financial stability.

If taking on more debt could jeopardize your financial health, consider alternative financing options, like equity investments or grants, and keep your business’s financial goals and risk tolerance in mind when making a decision.

Conclusion

In this article, we covered key aspects of understanding and managing liabilities, from different types of liabilities to particular liability accounts and how to account for specific transactions—and how liabilities can and should impact your business choices.

To make informed decisions, track your liabilities carefully, manage them effectively, and align them with your business goals.

Next, check out our articles on understanding double declining balance depreciation, how to calculate the current ratio, and 14 common accounting errors and how to avoid them.

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