All small businesses have liabilities whether it involves payment to suppliers, repayment of business loans, payment of salaries to employees, or advance payments from customers. Liabilities refer to all these financial obligations, and the knowledge of such liabilities is very important for proper record keeping. Knowledge of liabilities within accounting ensures that the small business is able to keep track of future payments, control its cash flows, and measure the financial status of its operations.
In this blog, we are going to provide an overview of the various liabilities, look at some of the typical liabilities in small businesses in the United States, and discuss the impact of such liabilities on financial accounts and decision making.
What Are Liabilities in Accounting, and What Are Their Main Types?
Liabilities are obligations that a business already has from transactions or events that have occurred previously. Liabilities are recorded in the balance sheet and are usually amounts that need to be paid by the business through giving something in return.
Current Liabilities: Short-Term Financial Obligations
Current liabilities are debts that are anticipated to be paid within one year or the operating cycle of the business, whichever is longer. Current liabilities comprise bills from suppliers, salaries payable, short-term loans, and the part of long-term loans that will be repaid within the coming year. Since these debts are due soon, they are very significant in short-term planning for cash flow.
To illustrate, let us consider a situation where a retail business buys inventory worth $8,000 on credit, which will be paid within 30 days. The business has recorded $8,000 as accounts payable until it pays the bill. Even though this transaction increases inventory, it also increases the current liabilities of the business that needs to be planned for.
Long-Term Liabilities: Obligations Due Beyond One Year
Non-current liabilities or long-term liabilities can generally be defined as obligations which are not due to be paid in one year or within the normal operating cycle. Typical long-term liabilities include long-term business loans, mortgage, some lease payments and bond payable. Such obligations typically result from financing of business machinery, property or expansion.
If a business takes a loan of $100,000 to buy manufacturing machinery and agrees to pay back the loan in five years, then any part of the debt due in the next twelve months would typically fall into current liability category, whereas the remaining debt would fall into long-term category.
Contingent Liabilities and Other Accounting Obligations
Other possible liabilities may be dependent on certain uncertainties that will happen in the future. They are called contingent liabilities. These liabilities could include some pending litigation cases, warranty liabilities, and guarantees. In terms of GAAP, the loss contingencies whether should be recognized or not depend on some parameters like the probability of the losses and whether its amount is estimated or not.
Sometimes, small businesses can deal with deferred revenue that occurs when customers make payments before providing goods or services to them. For example, if a consulting company gets $6,000 as payment for six months of services rendered, the business will have contract liabilities. It will recognize the revenue as it meets performance obligations. Having the cash payment doesn’t mean that the revenue was generated yet.
Common Examples of Liabilities for Small Businesses
Liabilities may arise in small businesses due to regular buying, payment to employees, borrowing, and business with customers. Accurate identification of the liabilities will ensure that there is no under-statement of expenses and overstatement of income.
Accounts Payable, Accrued Expenses, and Payroll Liabilities
The accounts payable consists of money owed to vendors for goods or services rendered on credit. The accrued expenses are expenses that have been incurred but are not yet paid, which includes salary payable, accrued interest, and utility expense. In the case of accrual accounting services, the recording of liabilities usually occurs on when the liability is incurred, rather than when the payment is made.
Special care should be taken in the case of the payroll liabilities since they may include unpaid salaries of employees, income tax withholdings, payroll taxes paid by both the employees and employer, and the amounts paid towards benefits. These should be kept in different records and submitted as per the required deadlines.
Business Loans, Credit Cards, and Lease Liabilities
A loan and a credit card are two examples of how companies fund their operations. A loan generates liability for the outstanding amount of the loan, whereas interest usually results in an expense. Purchases made through a credit card generate an expense or an asset and a credit card liability.
Leasing arrangements may also lead to creation of liabilities. In general, under US GAAP, most companies that apply ASC 842 will recognize the leasing arrangement liabilities and the right of use assets. However, companies that use tax basis or other special purpose frameworks of accounting may report their transactions differently.
Sales Tax Payable, Deferred Revenue, and Other Obligations
The businesses which charge the sales tax from their customers usually recognize this tax charged as a liability and not as revenue, since this tax charge would need to be paid out to the concerned state or local tax authorities. The obligations of sales tax differ with jurisdictions, hence maintaining proper records of transactions becomes critical for the businesses operating in various states.
The deferred revenues are other forms of liabilities maintained by businesses where the businesses receive deposits from the customers. Some of the other liabilities could be the liability of customer refund, warranty liability, and professional fees liability.
Examples of current and long-term liabilities
|
Liability |
Example |
Typical classification |
|
Accounts payable |
Unpaid supplier invoice |
Current |
|
Wages payable |
Earned but unpaid employee wages |
Current |
|
Payroll taxes payable |
Taxes withheld or owed |
Current |
|
Sales tax payable |
Tax collected but not remitted |
Current |
|
Customer deposits |
Payment received before delivery |
Current or long-term |
|
Business loan |
Outstanding loan principal |
Current and long-term portions |
|
Mortgage |
Loan secured by business property |
Current and long-term portions |
|
Lease liability |
Qualifying equipment or property lease |
Current and long-term portions |
Classification depends on the applicable accounting framework, payment terms, and expected settlement dates.
How Liabilities Affect Financial Health and How to Manage Them
Liabilities, by themselves, are not necessarily bad. Liabilities can assist in purchasing assets for the firm, expanding the business, or dealing with seasonal working capital needs. But liabilities have to be managed carefully so that repayments remain in sync with cash flow.
Understanding the Balance Sheet and Financial Ratios
Liabilities are one of the three components of the fundamental accounting equation:
The accounting equation
Assets (What the business owns) = Liabilities (What it owes) + Equity (Owners’ residual interest)
For instance, when the value of a firm’s assets is $150,000 and its liabilities amount to $60,000, the owner’s equity will be $90,000. The balance sheet shows the financial status of the organization on a certain date whereas financial ratios assist owners and lenders in interpreting this data. Current ratio compares current assets and current liabilities, and debt/equity ratio analyzes the borrowing and owner’s equity.
A large balance of liabilities does not necessarily indicate financial problems. Its importance will depend on the industry, cash flow, terms of repayment, profitability, and capability of satisfying future financial obligations. Financial ratios should be analyzed over a period of time in order to identify any change which might require attention.
Managing Cash Flow and Preventing Overdue Payments
Proper management of liabilities starts by ensuring that there is knowledge of when the payments are due. A business must ensure that its schedule of accounts payable is kept up to date; the amounts of installments to be paid in regard to loans and those for payroll and taxes must be forecast.
The owners must ensure proper reconciliation of liability accounts. This can be done by comparing supplier statements with the accounts payable, the loan balances with the lender statements and payroll taxes with the payroll statement.
Using Accounting Software and Professional Support
Programs like QuickBooks and Xero can assist businesses to keep track of their unpaid invoices, loan balances, categorize transactions, and prepare balance sheets. Nevertheless, computers will not be able to independently verify if all obligations have been accurately accounted for. Bookkeeping and periodic review of finances is still essential.
A hired accountant or bookkeeper can be helpful in resolving accounts payable issues, preparing loan schedules, accounting for accrued expenses, recording payroll liabilities, and preparing periodic reports. This might be particularly helpful when a business raises additional funds and enters into new markets.
Knowing how liabilities work in accounting will help small business owners make sound financial decisions and keep their balance sheets in order. Current liabilities are obligations that the company has to pay in the future, whereas long-term liabilities are financial obligations that will span beyond one year. Proper identification and management of both liabilities is crucial for the business.
Keeping track of suppliers' bills, bank loans, payroll tax payments, customer deposits, and other types of financial obligations will enhance cash flow projections and help eliminate any unnecessary mistakes in accounting.
The Fino Partners provides outsourced accounting, bookkeeping, payroll, tax preparation, and financial reporting support for U.S. businesses and accounting firms. Our professionals can assist with maintaining liability schedules, reconciling accounts, and organizing financial records to support consistent reporting.
