What Are Liabilities in Accounting? With Examples
This article is part of a larger series on Bookkeeping.
In accounting, liabilities are amounts that your business owes to any individual or entity—be it customers, debtors, vendors, or the government. These include accounts payables (A/P), deposits from customers, and salaries and wages payable. Most small businesses only include these on their balance sheet when the fact of the amount owed has been established, such as after having received the vendor invoice.
Liabilities are expected to be settled in the future, so you can typically categorize them into two: current and noncurrent or long-term liabilities. However, determining these can be complicated for companies that must follow generally accepted accounting principles (GAAP), as they must also recognize contingent liabilities (more on this later).
Essential Characteristics of Liabilities
Recognizing liabilities in the balance sheet can be tricky and confusing in bookkeeping. However, if you know the characteristics of a liability, you can categorize a transaction as one.
- It’s a present obligation that will be settled in the future using cash, goods, or services. For example, you have a bank loan that needs to be repaid after two years. Today, you have a present obligation to repay the loan but the actual payment will be in two years’ time.
- It’s an unavoidable obligation. Liabilities often arise from contractual and legal obligations. In a contract, you agree to give or to do something for another person. If you don’t fulfill your obligations, the other person can sue or ask for damages. Take note that paying taxes is a legal obligation, which is unavoidable.
- It’s a result of a past event. Past events give rise to a liability. Examples are transactions to purchase goods or services on credit.
A liability is current if it’s due in less than 12 months or within the normal operating cycle, whichever is shorter. But for simplicity in a small business setting, we can set the period for current liabilities as due in less than one year.
Part of current liabilities are accrued expenses, which are expenses already incurred but not yet billed or paid). You can record this type of expense to account for the consumption of goods and services, such as electric, water, and gas bills, or for work performed by employees during the month.
In a small business, recognizing accrued expenses isn’t compulsory. You can record an A/P for bills as they’re received, regardless of when the expense was incurred. Some small businesses don’t even record A/P and, instead, wait to record an expense until the bill is paid.
If you use accounting software like QuickBooks Online, you record A/P automatically when you enter bills in the system.
Examples of Current Liabilities
In a small business environment, the common current liabilities include obligations related to operations and payroll. Here are some examples.
- A/P: This account represents balances you owe to suppliers for goods and services purchased on account.
- Notes payable: Also called trade notes payable, this account represents the value of promissory notes or written promises to pay a certain sum of money.
- Advances or deposits from customers: This account reports returnable cash deposits from customers. Examples of these deposits are cash deposits for the lease of equipment as a guarantee for possible damage.
- Unearned revenues: This account represents prepayments from customers for goods and services that haven’t yet been delivered or performed.
- Sales taxes payable: This account represents sales taxes collected from customers that haven’t yet been remitted to the taxing authority.
- Payroll taxes payable: This account includes Social Security tax, Medicare tax, and federal income tax that has been deducted from employees’ paychecks but hasn’t yet been remitted to the IRS.
- Salaries and wages payable: This account represents the net compensation of all employees that haven’t yet been paid.
There are also special liability accounts that are required under GAAP but often ignored by small businesses not required to comply. However, you might encounter them as your business expands.
- Accrued interest payable: Accrued interest is interest due on a loan that hasn’t yet been paid.
- Dividends payable: These are dividends declared to stockholders but not yet actually paid.
- Current portion of long-term debt: This is the portion of long-term debt, such as serial notes and bonds, which are scheduled for payment within 12 months. A serial note or bond is a long-term debt that’s paid in a “series” of principal and interest installment payments.
- Currently maturing long-term obligations: This is a long-term debt that’s about to come due within 12 months.
Noncurrent or Long-term Liabilities
A liability is noncurrent if it’s expected to be settled for a period of more than 12 months. Some long-term liabilities also require the application of the time value of money, such as leases, pensions, and notes.
Examples of Noncurrent Liabilities
Small businesses typically don’t have many noncurrent liabilities, but you may experience more of these as you expand or enter special transactions.
- Bonds payable: This is a liability account that records the indebtedness for bond certificates issued to creditors.
- Long-term notes payable: A long-term note is a promissory note with a maturity of more than 12 months.
- Mortgage payable: This liability account records the unamortized or the unpaid amount of the mortgage loan.
- Deferred tax liability: This account records future tax consequences arising from taxable temporary differences. This difference happens when increases in revenues or decreases in expenses are included in accounting income but not in taxable income. The United States GAAP requires companies to report deferred tax liabilities as noncurrent liabilities even if a portion of it’s due within 12 months.
- Pension liability: This account presents the underfunding of pension assets in a defined benefit plan.
- Lease liability: This account shows the present value of minimum lease payments for leases under the capital lease method. For a small business, you can instead use the operating method for expediency and simplicity. Under the operating method, all lease payments are charged to rent expenses.
A contingency is an existing condition or situation that’s uncertain as to whether it’ll happen or not. An example is the possibility of paying damages as a result of an unfavorable court case. The condition is whether the entity will receive a favorable court judgment, while the uncertainty pertains to the amount of damages to be paid if the entity receives an unfavorable court judgment.
US GAAP requires some businesses to disclose or report contingent liabilities. Small businesses that aren’t required to comply with the US GAAP may opt not to consider contingencies in financial reporting.
Most contingent liabilities are uncommon for small businesses, but here are some that you might encounter.
Examples of Contingent Liabilities
- Loss contingencies: These are probable and measurable losses that you’ll have to pay in the future as a result of a past event. An example of a loss contingency would be the estimated cost of product recalls due to defects.
- Litigations, claims, and assessments: These are contingent liabilities arising from pending or threatened litigation or possible claims and assessments.
- Warranty liability: This liability arises from assurance-type warranties, where the seller promises to make good on a deficiency or poor quality of a product. Assurance-type warranties come with the product. For example, refrigerator manufacturers often give 10-year service warranties for factory defects and minor repairs.
- Unearned warranty revenue: This liability arises from service-type warranties where the seller sells a separate warranty contract. An example of this warranty would be AppleCare for Apple Products. By buying AppleCare, you can get an extended warranty after the standard warranty expires. Apple must initially report the amount received as “unearned” and then gradually recognize it as revenue when the service has been performed or the contract expires.
- Premium liability: A premium liability arises from promotional programs to entice customers to buy your products in exchange for a premium. A famous example of a premium would be the annual Starbucks planner. If customers can collect a certain number of stars for every beverage ordered, they can get the planner for free. Since it’s impossible to ascertain the actual number of redemptions, the U.S. GAAP requires Starbucks to use estimates and record a contingent liability.
- Environmental liabilities: This liability arises from noncompliance with environmental safety regulations of the EPA.
A liability is a major component of the accounting equation. In a small business, these usually are simple because they only pertain to basic things, like A/P, loans, salaries, and taxes. However, as your business grows and needs to comply with the US GAAP, there are other types that you must consider for accounting purposes.
Understanding what liabilities are in accounting, as well as the most common examples of each type, can help you track and identify them in your balance sheet.