Liability: Meaning, Types, and What Do Companies Do With Liabilities 

One of the basic accounting and financial reporting principles to have is liabilities. A company can owe money to a bank, money due to a supplier on credit, a customer for a service that it has provided but has not yet been paid, or money that is owed out because the company has made an expense that has not yet been paid. 

Liabilities are crucial for businesses to know about their financial condition. They provide investors, lenders, management, and other stakeholders with information about the amount of debt that a company owes. Let’s understand more about liabilities ahead. 

What is a Liability?

A liability meaning is an obligation of a present duty arising from a past transaction or event that will likely lead to the transfer of an economic resource in the future. 

If a business buys $10,000 of inventory from a supplier but has 30 days to pay the supplier, its total assets would increase by $10,000. The company immediately gets the inventory but must pay later. The $10,000 is then a liability on the books called accounts payable until it is paid. 

Most of the liabilities are listed on the balance sheet, a statement that reflects the financial condition of a business at a specific moment in time. 

A balance sheet is generally broken down into three sections: 

• Assets: Items that the company owns or has control over that are likely to benefit the company in the future.
• Liabilities: All debts that a company has to outside parties.
• Shareholders’ Equity: Net worth of the company for the shareholders.

How Do Liabilities Work?

Generally, a liability is created when a business has received a product or service and is yet to pay for it. 

Imagine that a company borrows $100,000 from the bank. The business receives $100,000 in cash, but the cash becomes an asset to the business. Plus, it is an obligation to repay the bank, and the $100,000 loan is thus regarded as a liability. 

A business can be given raw material by a supplier and agrees to pay for it later. It may use employees and pay them wages at the end of a pay period. There can be obligations that arise in each situation that need to be addressed. 

Importantly, a company that has liabilities does not necessarily mean that it is a poor financial health company. Debts and other liabilities are often used to fund business activity, the acquisition of assets, and expansion. The significant test is whether the business is able to pay its debts when they fall due. 

Liabilities and Accounting Equation 

Liabilities are directly related to the basic accounting equation: 

Shareholders’ Equity = Assets – Liabilities

The equation is a representation of the way in which a company is financed. 

Suppose that a company has: 

Assets = $1,000,000

Liabilities = $400,000

Equity = $600,000  

The accounting equation will be

$1,000,000 = $400,000 + $600,000

You can also work out the value of the liabilities: 

Shareholders’ Equity = Assets − Liabilities

$1,000,000 − $600,000 = $400,000

This implies that $400,000 of the company’s resources are collected in the form of debts; the other $600,000 are collected in the form of shareholders’ equity. 

Also Read: Bank Statement: What It Is, How to Get It, and Its Importance

Current vs. Non-Current Liabilities 

Companies categorize their liabilities based on the time they are due. There are two broad types of liabilities: current and non-current liabilities. 

1. Current Liabilities 

Current liabilities are debts that must be paid within one year or the company’s operating cycle, whichever is shorter, and according to the type of accounting framework. 

Common examples under this type of liability: 

Accounts Payable: These are the amounts that the company is liable for to the suppliers and vendors where the company has received goods and services. 

For instance, when a retailer acquires $20,000 worth of goods on credit, he or she is obligated to pay back the supplier for the $20,000 in a timely manner. 

Accrued Expenses: These are the costs that have been incurred by a company but not paid. This can be anything such as salaries, utilities, interest, etc. The company knows that it is going to have to pay for it, but it does not expect to have to pay for it for quite a while.

Short-Term Debt: It refers to debts that are payable within the short-term period. It may comprise some bank loans and credit facilities or the current portion of the long-term debt. 

Wages Payable: Staff can receive wages before they have actually received the payment from the company. The unpaid amount is an obligation, and it is reported as wages payable. 

Taxes Payable: Government authorities could have income tax, payroll tax, sales tax, or other taxes. Outstanding amounts that are payable, but not yet paid, are listed in the Liabilities column.

2. Non-Current Liabilities 

Non-current liabilities will be those obligations that are expected to be settled in the following 12 months.

Examples include: 

• Long-term Loans: These are loans that are due to be repaid for more than 1 year. Long-term loans are taken by businesses for large expenses like property, machines, equipment, etc. 
• Bonds Payable: Its the obligations that a company has towards investors due to the issuance of bonds. The company will pay back the principal on a set date in the future, and typically pay interest on the bond as agreed. 
• Long-term Lease Obligation: These are the amounts due to be paid by the company under the lease may relate to payments beyond the next 12 months. 
• Deferred Tax Liabilities: It is typically a result of a temporary difference in the accounting of an item and its tax treatment. This can lead to taxes that are anticipated to be payable in subsequent periods.
• Pension and Post-employment Liabilities: These obligations are associated with the benefits a company expects to pay its employees upon retirement or their departure from the company. 

For instance, a company could obtain a 10-year loan to buy a manufacturing plant. The amount payable after one year is normally considered a non-current liability, and the amount payable within one year may be considered a current liability. 

Liabilities vs Assets 

The balance sheet includes two sides: assets and liabilities. 

An asset is a resource a company owns or controls that will provide an economic benefit in the future. A liability, however, is an obligation that the company will normally have to pay in the future. 

For instance, if a company has cash on hand, it is considered an asset since it can be utilized for buying goods, paying workers, or settling other obligations. If the business takes out a bank loan, it is a liability because it must repay the amount to the bank. 

Some common examples are: 

Assets	Liabilities
Cash Inventory  Buildings Machinery Accounts receivable Investments	Bank loans Accounts payable Taxes payable Accrued expenses Lease obligations Bonds payable

Liabilities vs Expenses 

An expense is a cost that a business incurs in running the business and generating income. Typical expenses are listed on the income statement. A liability is an obligation that the company has and is normally recorded on the balance sheet. 

For instance, when a company consumes electricity in December but only pays the electricity bill in January. During December, the electricity consumption is an expense. The unpaid amount is a debt that is due until the company settles the bill. 

Likewise, a company can have employee salaries for one month and pay employees in the following month. The salary will be an expense, and the unpaid amount will be wages payable. 

A liability may then occur due to an expense, but an expense does not always result in a liability. 

What Do Companies Do With Liabilities?

Good debt management and investment strategies are a vital component of financial stability. It is important that companies keep track of their liabilities and ensure that they have enough resources to meet them at the time they fall due. 

A business can control its liabilities in the following ways: 

• Ensuring that bills are paid on time. 
• Keeping a healthy safety margin of cash notes. 
• Efficient handling of accounts payable. 
• Limiting unnecessary borrowing. 
• Debt refinancing if it is appropriate.
• Arranging payment with suppliers.
• Checking and revisiting debts and interest payments.

A firm’s liability management can facilitate the liquidity needs without sacrificing its ability to fund the business with debt or other means.

Final Words 

Liabilities are an integral component of accounting and financial reporting. They are commitments that a company holds to suppliers, lenders, employees, governments, customers, and others. 

Knowing about liabilities also gives a good idea of the financial structure of an organization. We have covered everything about liabilities, what is and how they work in this blog. 

Read Next: What is Single Touch Payroll? – Its Benefits, Common Mistakes, and Reporting Process

FAQs 

Sources: 

• Liabilities – By WallStreetPrep 
• What are Liabilities – By Xero