Definition of a Liability Account
A Liability Account is a general ledger account where the credit transactions of a firm are recorded. The balances under a Liability Account are the debts owed by the business to a few third parties who are directly or indirectly involved in the functioning of the business.
Maintaining a Liability Account is the proper way of storing all the legally binding obligations that are payable to several parties involved in the business. Liability Account helps businesses track business debt in a professional manner.
The occurrence of a new credit transaction causes an increment in the liability account balance. Whereas a debit transaction causes a decline in the liability account balance.
Understanding Liabilities
A liability can be defined as something that an individual or an organization owes to a third party or several parties. In general, liability is a sum of money. In the business world, liabilities are settled over time based on the nature of the liability.
Liabilities are settled through the transfer of assets or goods holding economic benefits. Money is used as a source to clear liabilities. The liabilities of a company are recorded on the right side of the balance sheet, which is one of the most important financial statements of any business.
Liabilities are categorized into two types based on the duration of their time. The two major categories of liabilities are Current Liabilities and Non-Current Liabilities. Several liabilities of businesses are divided between these two. The major difference here lies in the duration period of the liabilities. Current Liabilities are also referred to as short-term liabilities. Non-Current Liabilities are also known as long-term liabilities.
Debtor and Creditor Classification
“Debtor” and “Creditor” are two financial terms that you must understand to have a clear picture of various business accounts. Whenever a transaction is incurred in the business, between any two parties, one of them is considered as debtor, and the other one is considered as creditor. The party who owes the money is the debtor category, and the party receiving the money is the creditor.
Types of Liabilities
There are several types of liabilities. Liabilities owed by any company are subjective and highly dependent on the nature of the company. However, the most general types of liabilities which can be traced in the financial statements of every firm are as follows:
Accounts Payable
An accounts payable account details credit owed to suppliers for products or services which have not been paid for. Invoices are approved and ready for payment, but balances are unpaid. Accounts payable is considered a current liability. This account majorly covers the pending payments to various vendors and suppliers.
Accrued Expenses
In an accrued expenses account, expenses are incurred, but paid for in the next accounting period. Included in this account are unpaid bills, unpaid invoices, and unrecorded wages. Accrued expenses are those liabilities that are recorded in the business books but are paid for in the future.
Short-Term Loans
A short-term loan payable account details loan amounts due within a year of the date entered in the balance sheet. These loans are generally taken out by the business for emergency personal/business needs. These types of liabilities are highly temporary in nature.
Long-Term Debt
A current portion of a long-term debt account details portions of long-term debt that must be paid within a year of the date entered in the balance sheet. Debt not due within a year should be reported as a noncurrent liability.
Unearned Revenue
Unearned revenues detail payments received before products or services have been rendered. Liabilities will equal revenues until products or services are delivered. Unearned Revenues are considered a liability because they are the debts that the firm owes to the clients/customers.
Mortgage Loan
Mortgage loans payable refers to long-term loans with real estate. This account can be broken into current and noncurrent liabilities: payments due within a year of the balance sheet date are current liabilities and payments due in more than a year are noncurrent liabilities. However, because interest is not payable as per the balance sheet, future interest should not be recorded as a liability.
Bonds Payable
Bonds payable refer to long-term debt issued to finance new projects or to cover costs. Depending on the length of the bond’s maturity, it could be a current or noncurrent liability. If a bond matures within a year of the balance sheet date, it is a current liability. If a bond is refinanced by issuing new bonds, it is a noncurrent liability.
Instalment Loans
Instalment loans payable refers to loans paid over time, usually in monthly increments. This account can be broken into current and noncurrent liabilities: payments due within a year of the balance sheet date are a current liability and payments due in more than a year are noncurrent liabilities. However, because interest is not payable as per the balance sheet, future interest should not be recorded as a liability.
Lastly, as a business owner, it is important for you to keep track of the money owed by your business and ensure that you clear these debts as soon as possible.