Liability is what a company owes.
Liability represents things that a business owes to other parties and promises to pay them back in the foreseeable future. As one of the three types of accounts on the Balance Sheet, liability is an important area in accounting and financial analysis.
Characteristics of Liability
Academically speaking, liabilities have the following two characteristics:
1. There will be an outflow of resources in the future
- Business Loan. A loan requires you to pay back cash one month at a time for the next few years, which means there will be an outflow of resources (in this case, cash) in the future.
- Unpaid utility bill. A business has to pay the utility bill that will be due soon, which means there will be an outflow of resources (cash).
2. It is caused by a past event
- Business Loan. A business has to repay the loan because it borrowed it sometime in the past, and therefore, the whole transaction is due to a past event.
- Unpaid utility bill. The company incurred the bill because it used electricity in the past month. Therefore, it is due to a past event.
To conclude, all the liabilities share the said two characteristics. Simply speaking, it’s just what a business owes. Professionally speaking, it’s an outflow of future resources due to a past event.
Let’s say you are a basketball player, and your coach yells at you, “You are such a liability to this team.” What did he mean? he meant you are a disappointment because you will cost the team winning opportunities in the future (outflow of resources at a future date) as a result of recruiting you to the team (caused by a past event) – oops, time to switch career and be an accountant!
Real-world Simple Example
Pho my Life Noodle Shop (PML) has the following liabilities on its balance sheet.
- Accounts Payable $300 = the amount the PML noodle shop promised to pay back to its supplier. For instance, the PML noodle shop has ordered $300 worth of to-go boxes from a supplier and received an invoice with a net 30 term (payback within 30 days). Before the PML noodle shop pays them back, it has to record accounts payable of $300 because they owe the supplier as they’ve placed an order.
- Accrued expenses $900 = This represents how much expense the PML noodle shop has incurred/used before they even receive the bill, such as electricity. Before receiving that electricity bill, the PML noodle shop has to record an accrued expense to accurately reflect how much they’ve spent on electricity, which is a liability because they will have to pay the bill as they need electricity every day to operate the restaurant.
- Unearned revenue $200 = This is the amount that the PML noodle shop has received in cash but has yet to perform any service to actually earn it. Why is it a liability? For instance, the PML noodle shop wants to stay with the trend and starts selling gift cards that can be redeemed at their restaurant. The PML noodle shop has so far sold $200 worth of gift cards for which they’ve received $200 in cash. These cards haven’t been redeemed by their customers yet. Therefore, they are a liability because it requires them to serve food at a future date (outflow of resources in the future) as a result of selling the gift card and receiving the cash ahead of time (past event). Simply speaking, they owe the food to their customers, which is a liability they will have to recognize on the balance sheet.
Common Types of Liability
Here is a list of common types of liabilities – all explained in simple words
- Accounts Payable (AP): This is how much a business owes its suppliers, which is typically short-term. Accounts Payable refers to any services or goods a company has received but has not paid for.
- Loan/Notes Payable: This represents how much a business owes the bank or other financial institutions due to taking out a loan or borrowing long-term notes. For example, mortgages and business loans belong to this category. Given its long-term nature, this type of liability is separated from the regular Accounts Payable.
- Accrued expenses: This represents the amount owed for expenses incurred but not yet invoiced. Typical examples are electricity and water bills, as they will be due after a period has concluded. Another example is payroll – you likely will pay your workers after they’ve done their jobs for two weeks. But before you pay them, you’ve incurred those labor costs as they’ve already put in the work, and you technically owe them at that time.
- Unearned revenue: The amount of money a business has received but has not performed any service in return. In other words, a company has yet to truly earn this money because it still needs to put in the work later. It’s a liability because the business owes its customers the “services” that they’ve already paid for. Typical examples include customer deposits, gift cards, or vouchers for which a business has received cash.
- Tax Payable: As tax is typically paid after a full year has concluded, businesses often record tax payable as a separate line on their balance sheet due to its significance. They must record and disclose how much they will need to pay the tax authority in a few months.
Current Liabilities vs. Non-current Liabilities
The key difference between current liabilities and non-current liabilities is timing – depending on how soon a business will have to pay off that liability. The cutoff is one year. If a business has to pay off that debt within a year, it’s considered a current liability. Otherwise, it’s a non-current liability.
Examples of current liabilities include
- Accounts Payable (AP) – invoice received but hasn’t been paid. Almost all invoices have a due date within 60 days of issuance. Therefore, AP is a typical current liability.
- Accrued Expenses – expense incurred that hasn’t been paid. It is very rare for a company to not pay for the service that they have incurred within a year. As a result, accrued expenses are a typical current liability.
- Tax Payable – taxes are usually due within a year. Therefore, it is a current liability.
To conclude, Current liabilities are debts a company expects to pay off in the short term or within a year.
Examples of non-current liabilities include:
- Notes/loans payable – most of the time, a loan will be outstanding for over a year. Therefore, typically, it is a non-current liability.
What if a business only has less than a year to pay it off? Then, it will be reclassified to current liabilities. In other words, the classification of current vs. non-current liabilities is flexible, and the only difference factor is timing, which is a year.
Q: Where do accrued liabilities go on the Balance Sheet?
A: Accrued liabilities are within the current liabilities section of the Balance Sheet.
Q: Why do liabilities have a credit balance?
Q: Can liabilities be more than assets?
A: Sure they can. However, from a business perspective, when liabilities are more than assets, the business will have a negative equity according to the Balance Sheet Equation and, therefore, is at risk of bankruptcy.
Q: When are liabilities recognized? When to record liabilities?
A: Liabilities are recognized right after a service has been rendered. For example, after a loan has been mowed or after a day of operation involving employee/labor costs.