A liability account is a category within the general ledger that shows the debt, obligations, and other liabilities a company has.
Balances in liability accounts are usually credit balances. This means that debit entries are made on the left side of the T-account which decrease the account balance, while credit entries on the right side will increase the account balance.
Liabilities are amounts owed by a corporation or a person to creditors for past transactions. Not all business transactions take place in cash. Some are made on credit. Whenever a transaction is made on credit, a liability is created. In other words, a company must pay the other party at an agreed future date.
In the case of non-payment creditors has the authority to claim or confiscate the company’s assets. Even in the case of bankruptcy, creditors have the first claim on assets. Companies are in constant need to raise cash. This can either be raised through equity (Issuance of shares on the stock exchange) or debt (Obtained from banks or issuance of bonds).
Liability Accounts Example
Bob from Bob’s Donut Shoppe Inc takes out a $100,000 loan from a bank over 10 years. The loan has an annual interest rate of 10%.
In the accounts, the liability account would be credited, which increases the balance by $100,000. At the same time, the cash account would be debited with the $100,000 of cash from the loan.
But what about the interest? At the end of the year, Bob’s Donut Shoppe would have paid a total of $15,858.12. This amounts to:
- $6,134.18 in principal
- $9,723.90 in interest
The principal amount is a decrease in the liability account and that would be debited $6,134.18, while the cash account would be credited the same amount.
The interest portion of the repayments would be posted to the interest expense and interest payable accounts. The $9,723.90 would be debited to interest expense, and the same amount would be credited to interest payable.
Non-Current liabilities have a validity period of more than a year. These are liabilities are the ones that are due after one year. Examples of non-current liabilities are as follows.
- Long-term debt. Long term debt is debt solicited from a bank that will not be due within a year from the date that it was obtained. Our earlier example is a classic example of a non-current liability. As the $100,000 loan had a maturity of 10 years, it would be classified as a non-current liability. The liability would continue to be recorded as a non-current liability until its last year of maturity.
- Mortgage payable. Mortgage payable is another liability that arises when a corporation/ person buys property on credit. It is again a long-term financing tool.
- Bonds payable. Issuing bonds is a technique used by corporations to raise finances through debt. Investors buy bonds issued and become lenders to companies. The finances would then be utilized by the company to make investments in assets. Bonds are also known as fixed-income securities and have different maturity dates. Bonds again are long term nature with due dates of more than a year.
Generally, a company may need more funds then a typical bank can provide, hence companies may resort to bonds to cover their unmet financing need. A company is liable to make annual interest& principal payments to these investors.
- Notes payable. Notes payable are written promissory notes, whereby a lender lends a specific amount to a borrower. The borrower promises to pay the amount with interest over a specific pre-determined time.
Current liabilities are liabilities owed by a company to a lender for 1 year or less. These liabilities are also known as short term liabilities. Some common examples of such accounts can be viewed below.
- Accounts payable. Short term credit is a common phenomenon amongst companies. Often companies buy raw materials or other goods on credit. Such types of transactions or obligations to pay are known as accounts payable. Normally credit period varies from industry to industry but generally a 30-day credit period is common.
- Accruals. As per accounting laws, companies should pay for services in the same period as they are available. However, often this is not the case. Most utility companies charge for their services in the next month, hence these are examples of accruals or short-term liabilities.
Similarly, companies might also avail services on credit. Large companies, for instance, may often pay for travel services of their employees at a later date than when they were availed. Again, such obligations would be recorded as accounts payable.
- Short-term debt. Debt can also be obtained from a bank for less than a year. This type of debt is also considered as short-term debt.
- Overdraft. Companies on occasion draw more from a bank account than that what it holds. Such facilities are utilized by small and medium enterprises. These facilities provide relief to companies for their short-term financing needs.
- Dividends payable. Companies that are listed publicly need to pay their shareholders in dividends. Unlike debt holders, shareholders have to be paid at the end. Hence, any dividends declared but not yet paid by the company are viewed as short term or current liabilities.
Advantage of Liabilities
- Help the company to raise finances. Companies experiencing cash flow problems can make use of liabilities to improve liquidity.
- Most small & medium-term businesses do not possess enough cash to expand their business. Through long term businesses and carefully crafted financial projections, such businesses could obtain finances from banks and hence grow operations. If the projects are successful, revenues obtained in the future could be used to repay such debts.
- Unlike shares, companies can maintain ownership and raise finances.
Disadvantages of Liabilities
- Companies eventually must pay more than what they borrowed. Cash paid through interest can hurt a company hard, especially if it is not doing well. When oil prices plummeted in 2015, high debt oil companies suffered immensely as they were not able to pay annual interest payments amid tough economic conditions.
- High debt can lead to a lower credit rating of companies which in turn can deter investment.
- Unlike equity, debt holders need to be paid even in bankruptcy. Debt holders can also claim assets upon nonpayment.
Having a sound understanding of liabilities is pivotal for business success. The financial manager must have the right mix of liabilities. Too much or too little can have adverse impacts that may continue to haunt the company in the future.