What is a Liability Account? – Definition
Liabilities are defined as debts owed to other companies. In a sense, a liability is a creditor’s claim on a company’ assets. In other words, the creditor has the right to confiscate assets from a company if the company doesn’t pay it debts. Most state laws also allow creditors the ability to force debtors to sell assets in order to raise enough cash to pay off their debts.
Debt financing is often used to fund operations or expansions. These debts usually arise from business transactions like purchases of goods and services. For example, a business looking to purchase a building will usually take out a mortgage from a bank in order to afford the purchase. The business then owes the bank for the mortgage and contracted interest.
Liability accounts have a credit balance. This means that entries created on the left side (debit entries) of a liability T-account decrease the liability account balance while journal entries created on the right side (credit entries) increase the account balance.
Types of Liability Accounts – Examples
There are many different kinds of liability accounts, although most accounting systems groups these accounts into two main categories: current and non-current. Current liabilities are debts that become due within the year, while non-current liabilities are debts that become due greater than one year in the future. Here are some examples of both current and non-current liabilities:
Accounts Payable – Many companies purchase inventory on credit from vendors or supplies. When the supplier delivers the inventory, the company usually has 30 days to pay for it. This obligation to pay is referred to as payments on account or accounts payable. No written contract needs to be in place. The promise to pay can either be oral or even implied.
Accrued Expenses – Since accounting periods rarely fall directly after an expense period, companies often incur expenses but don’t pay them until the next period. These expenses are called accrued liabilities. Take utilities for example. The current month’s utility bill is usually due the following month. Once the utilities are used, the company owes the utility company. These utility expenses are accrued and paid in the next period.
Bonds Payable – Many companies choose to issue bonds to the public in order to finance future growth. Bonds are essentially contracts to pay the bondholders the face amount plus interest on the maturity date. Bonds are almost always long-term liabilities.
Notes Payable – A note payable is a long-term contract to borrow money from a creditor. The most common notes payable are mortgages and personal notes.
Unearned Revenue – Unearned revenue is slightly different from other liabilities because it doesn’t involve direct borrowing. Unearned revenue arises when a company sells goods or services to a customer who pays the company but doesn’t receive the goods or services. In effect, this customer paid in advance for is purchase. The company must recognize a liability because it owes the customer for the goods or services the customer paid for.
That was a brief list of liability accounts. We will discuss more liabilities in depth later in the accounting course. Right now it’s important just to know the basic concepts.