The Accounting Equation – Liabilities Are What Your Company Owes
Most businesses owe something to someone. Whether you take out a bank loan to start the company, use a company credit card to pay for expenses, or buy your inventory from vendors on account, your company will show liabilities on the balance sheet. Even if you borrow your startup money from a family member or friend, it still counts as a liability on the company books.
Some very small service companies may not have any liabilities. When there’s no inventory, no payroll, and no company credit card, there really aren’t any debts to mount up. Unless there’s some major change in the business—for instance, you hire employees or start selling products—your balance sheet may remain liability-free, and that’s fine.
Like assets, liabilities are split into categories for easier ﬁnancial statement analysis. The division for liabilities is somewhat simpler, though, as it’s purely time-based. Any obligation that will be due within the next twelve months counts as a current liability. Debts that are expected to remain out- standing for more than a year are considered long-term liabilities. For ﬁnancial statement purposes, you count the current portion of a long-term liability (meaning the payments your company is scheduled to pay this year) along with the current liabilities; the balance of the loan remains in the long-term group. That’s it—no other rules and no other categories.
Most of your current liabilities will be those that occurred during your normal course of business. Buying inventory on account leads to accounts payable debt, for example, and paying employees prompts payroll tax liabilities. On the other hand, most long-term liabilities (other than any startup loans) come about as the result of ﬁxed-asset purchases, and those are not typically everyday occurrences once your business is up and running.
Money Isn’t All You Can Owe
In addition to owing money, there’s another kind of liability your business can have: it can owe products or services to customers. This liability comes about when you get paid in advance for something, and you have a legal obligation to either fulﬁll your part of the bargain or give the money back. Until you complete your part of the deal, whether performing services or delivering products, there will be a liability on your books. Most of the time, unearned revenue ﬁts in with current liabilities.
Any kind of company can have unearned revenues. Common examples include a lawyer who works on retainer, a retail shop that lets customers use a layaway plan, and a cabinetmaker who gets a down payment before starting work. In each of these cases, the business gets the money up front, before the full transaction is ﬁnalized, which means the company still owes something to the customer and is contractually obligated to provide it.
Once you fulﬁll your end of the deal, your unearned revenue will trans- form into regular revenue, courtesy of an adjusting journal entry. If you perform part of the service or deliver some of the product, only a portion of the unearned revenue will be adjusted.
The Interest Factor
Most long-term liabilities, and some current ones, come with an expense tacked on to them: interest. Loan payments typically include both a principal and an interest portion (just like your home mortgage payments); the same may go for current liabilities such as credit card payments.
When your payment combines these two different features, you have to deal with both in your journal entries. For example, suppose you’re making a $100 payment on the company credit card bill, and there’s an $18 interest charge on the statement (almost all credit card companies ﬁrst apply payments to interest, then balance). That payment would result in a $72 debit to credit card payable ($100 − $18), an $18 debit to interest expense, and a $100 credit to cash.
Here’s what your journal entry would look like:
Cash Payments Journal
|Date||Account/ Description||Accounts Payable||Purchases||Loan Payable||Credit Card Payable||Miscellaneous||Cash Credit|
For long-term loans, you may need an amortization schedule to ﬁgure out how much of your payment goes to principal and how much to inter- est. In this example, suppose you have a long-term loan on the books. Your monthly payments are $158.05. You look up this month on your amortization schedule and see that the current interest expense portion is $38.50.
That leaves $119.55 ($158.05 − $38.50) to apply to the liability account balance. The journal entry would look almost the same as the one above, but with two exceptions: the numbers would be different, and you write the debit in the loan payable column instead of credit card payable.