A liability is a a legally binding obligation payable to another entity. Liabilities are a component of the accounting equation, where liabilities plus equity equals the assets appearing on an organization's balance sheet.
Examples of liabilities are:
- Accounts payable
- Accrued liabilities
- Accrued wages
- Deferred revenue
- Interest payable
- Sales taxes payable
Accounting for Liabilities
For all of these sample liabilities, a company records a credit balance in a liability account. There may be rare cases where there is a negative liability (essentially an asset or a decline in a liability), in which case there may be a debit balance in a liability account.
The basic accounting for liabilities is to credit a liability account. The offsetting debit can be to a variety of accounts. For example:
- Accounts payable. The offsetting debit may be to an expense account, if the item being purchased is consumed within the current accounting period. Alternatively, the offsetting debit may be to an asset account, if the item is to be used over several periods (as is the case with a fixed asset).
- Accrued liabilities. The offsetting debit is nearly always to an expense account, since accrued liabilities are usually only recognized as part of the closing process, where there is an expense but no documentation in the form of a supplier invoice.
- Accrued wages. The offsetting debit is to the wage expense account, and reflects earned but unpaid hours at the end of the reporting period.
- Deferred revenue. The offsetting debit is usually either the cash account or the accounts receivable account, and reflects a situation where a customer has at least been billed for services rendered or goods shipped, but the revenue creation process is not yet complete. A variation on this concept is a customer prepayments account, or a customer deposits account.
- Interest payable. The offsetting debit is to the interest expense account, and indicates the amount of interest expense accrued by a business, but not yet billed to it by a lender.
- Sales taxes payable. The offsetting debit is the accounts receivable account, which is where the sales tax billing to the customer is located.
In short, there is a diversity of treatment for the debit side of liability accounting.
When presenting liabilities on the balance sheet, they must be classified as either current liabilities or long-term liabilities. A liability is classified as a current liability if it is expected to be settled within one year. All other liabilities are classified as long-term. Accounts payable, accrued liabilities, and taxes payable are usually classified as current liabilities. If a portion of a long-term debt is payable within the next year, that portion is classified as a current liability. Most liabilities are classified as current liabilities.
There are also cases where there is a possibility that a business may have a liability. This is known as a contingent liability. You should record a contingent liability if it is probable that a loss will occur, and you can reasonably estimate the amount of the loss. If a contingent liability is only possible, or if the amount cannot be estimated, then it is (at most) only noted in the disclosures that accompany the financial statements. Examples of contingent liabilities are the outcome of a lawsuit, a government investigation, or the threat of expropriation. A warranty can also be considered a contingent liability.
Other Liability Issues
When you record a liability in the accounting records, this does not mean that you are also setting aside funds to pay for the liability when it must eventually be paid – recording a liability has no immediate impact on cash flow.