As a small business owner, you might owe money to vendors, employees, and the government. You need to keep track of your business’s debts in your accounting books. When it comes to recording the money you owe, mark your debts as liabilities. What are liabilities?
What are liabilities in accounting?
In small business accounting, liabilities are existing debts that your business owes to another business, organization, vendor, employee, or government agency. You incur debts through regular business operations.
Liabilities can fluctuate daily as you add new debt and make payments. The more debts you have, the higher your liabilities are. And, the more debts you pay off, the lower your liabilities are.
Liabilities can make buying items for your business easier. With liabilities, you don’t have to pay immediately after you receive a good or service. Instead, the vendor sends you an invoice. You pay the amount due at a later date. Until you pay the invoice, the money you owe is a liability.
Liabilities also help you finance your company. For example, a small business loan is a liability that can help you grow your business. You owe the loan amount to the bank. But as you pay off the loan, you can use the borrowed money to improve and expand your business.
Here are some common examples of liabilities:
- Loans
- Accounts payable
- Mortgages
- Deferred revenues (advances paid by your customers)
- Accrued expenses (expenses recognized in your books before they’re paid)
All the above examples are debts that your company owes. To record debts in your books, you need to know the different kinds of liabilities.
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Short-term vs. long-term liabilities
Liabilities are separated into two types: short-term and long-term. Both types of liabilities affect your finances differently.
Short-term liabilities are also called current liabilities. You pay short-term liabilities within one year of incurring them.
Examples of short-term liabilities include:
- Employee wages
- Accounts payable
- Utilities
- Supplies
- Invoices
Long-term liabilities are also called noncurrent liabilities. You pay long-term liabilities over a period that is longer than one year.
Examples of long-term liabilities include:
- Accrued expenses
- Loans lasting more than one year
- Mortgages
- Deferred taxes
Recording liabilities on the balance sheet
Record your business’s liabilities on your small business balance sheet. The balance sheet is a financial statement that shows your assets, liabilities, and equity. The balance sheet reveals a snapshot of your finances that compares what your business owns to what it owes.
Liabilities play a major role in understanding your business’s profitability. To keep track of debts, record liabilities on the right side of the balance sheet. You should continually make records as you incur new debt and pay existing debt.
Short-term liabilities appear first on the right side of your balance sheet. List long-term liabilities after the total short-term liabilities.
The balance sheet is at the core of accounting for business owners, and is a great tool for understanding your finances. Here is an example of recording liabilities on the balance sheet:
| Assets | Liabilities | ||
| Cash | $17,500 | Accounts Payable | $735 |
| Accounts Receivable | $12,432 | Notes Payable | $1,500 |
| Inventory | $8,230 | Total Short-term Liabilities | $2,235 |
| Total Short-term Assets | $38,162 | Paid in Capital | $500 |
| Office Furniture | $3,510 | Total Long-term Liabilities | $500 |
| Office Equipment | $6,107 | ||
| Total Long-term Assets | $9,617 | Total Liabilities | $2,735 |
| Equity | |||
| Owner’s Equity | $20,000 | ||
| Retained Earnings | $25,044 | ||
| Total Assets | $47,779 | Total Liabilities and Equity | $47,779 |
The balance sheet doesn’t just help you see how much your company owes. It also helps you secure financing from a bank, lender, or investor. A creditor might ask to review your balance sheet to determine the level of risk involved in working with you. The higher your liabilities, the bigger risk you are to the creditor.
Liabilities and assets
On the balance sheet, you record both liabilities and assets. Your business’s liabilities and assets directly correlate with each other.
Assets are the items your business owns that add value to your company. For example, buildings, equipment, accounts receivable, cash, and intellectual property are all assets. By comparing assets to liabilities from your balance sheet equation, you can find your net ownership within the company.
Your ownership in the business is called owner’s equity. If you are a sole proprietor, you can find your owner’s equity by subtracting the liabilities from assets.
Assets – Liabilities = Owner’s Equity
If you have more assets than liabilities, you have positive equity. That means you can pay your debts and have money left over.
If you have more liabilities than assets, you have negative equity. Negative equity means you owe more to debtors than you own.
Difference between expenses and liabilities
As you complete your books, know the difference between business expenses and liabilities. Liabilities are the debts your business owes. Expenses include the costs you incur to generate revenue. For example, the cost of the materials you use to make goods is an expense, not a liability.
Expenses are directly related to revenue. By subtracting your expenses from revenue, you can find your business’s net income. Liabilities are not related to revenue. You cannot find net income with liabilities.
Record expenses and liabilities on different financial statements. Liabilities are found on the balance sheet. Expenses are found on the income statement.
As a small business owner, you need an easy way to record all your incoming and outgoing money. With Patriot’s online accounting software, you can complete your books in a few simple steps. Try it for free today!
This article has been updated from its original publication date of September 12, 2012.
This is not intended as legal advice; for more information, please click here.