To have a liability means that you are obliged to satisfy a debt. In simple terms, a liability is what you owe. Liabilities can take on 3 forms namely:
- Cash you owe to your lenders
- Cash owed for goods received but not paid
- Obligations you owe your customer
Cash you owe lenders
Cash you owe lenders is money borrowed from a bank or any other lending institution. When you have liabilities in your business, you give others claim to your assets. For example if you take a loan to buy an equipment, the bank can rightfully take back the equipment if you cannot pay.
When your borrow money from a bank, you categorize it in your financial software as a loan or note payable. Once a liability has been incurred, it remains a liability until it has been settled.
The payments you make on your notes, should not appear in your financial software as an expense. Payments of liability are used to reduce the amount you owe. However, the interest on the liability payment should be recorded as interest expense.
Cash owed for goods received but not paid
Sometimes, business owners buy supplies or inventory on credit. This event creates a liability for the business. When an item is bought on credit, the accounts payable account should be used to record the obligation.
Obligations owed to customers
It is not uncommon for customers to prepay for services or goods. When this happens, you owe an obligation to the customer. The customer still has a legal right to the cash they paid you if you default in your obligation. When customers prepay for obligations, do not classify the payment as “revenue” but rather use the liability account “unearned revenue”. When customers pay in advance, you are indebted to them until you perform the service or deliver the product.
Other examples of liabilities and their definitions are as follows:
| Account |
Definition |
| Accounts payable | Is a promise to pay a supplier or vendor for goods delivered now. It’s analogous to buying on credit or buying on account. That is, buy now and pay later. |
| Short term notes payable | Short term notes are promissory notes due in less than 12 months. Short term notes should be used to finance short term cash needs. |
| Line of credit | A line of credit is credit extended by a bank and is available to the borrower at their discretion. A line of credit works a lot like a credit card in that you are extended a credit limit and you do not have to reach your limit every month. The total amount is due in the next billing cycle and any amount not paid is charged interest. Line of credit are good for stabilizing cash flow. |
| Wages payable | Wages payable is an account used to record the cash amount you owe your employees for time they have worked but not being paid. This amount is usually determined at the close of an accounting period. |
| Interest payable | This is the interest owed on unpaid loans, notes or any other payables the business may have. |
| Unearned revenues | Unearned revenue is a prepayment for goods and services. As a result, you owe the customer the good at a later date. You do not earn the cash given to you until the service is performed. |
| Long term notes payable | Is a note with a payment due longer than 12 months |
| Long term loans | A loan is paid in installments and is normally due over a 12 month period. |
Classification of liabilities
Just like assets, liabilities are also classified as long or short term.
Long term liabilities: are debt that are payable in over a year
Short term liabilities: are payable under a year.
In the next article, I will talk about equity.