Liabilities are the items owed by the business. They are non-current also known as long-term or they are current also known as short-term.
Non-current or long-term liabilities are items that are paid off in more than one year. They are used to pay for fixed assets that are kept in the business for a long period.
Current or short-term liabilities are items that the business pays off in less than a year. They are used to finance cheaper fixed assets, current assets and expenses.
In accounting, when liabilities increase, they are recorded on the credit side or the right side of the ledger account. When liabilities decrease, they are recorded on the debit side of the ledger account. Similarly, when Income and Capital increase they are credited and when they decrease, they are debited.
In financial statements, liabilities appear in the balance sheet under assets using the vertical format and on the right side of the T account using the horizontal format. Here is a list of liabilities that usually appear in basic accounting and their treatment.
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Liabilities determined by agreement
Unlike assets that are classed under non-current based on their permanency and current based on their liquidity, liabilities are a bit more technical. Some items are clear cut long-term and some short term, while the period for some is determined by an agreement made between the business and the supplier.
When the business borrows money from the bank, it is a bank loan and the agreement can be made for long term or short term. The period of the loan determines which heading it is placed under in the balance sheet. When the borrowed cash or cheque is received from the bank, the current asset account Cash or Bank increases or is debited and the liability account Bank Loan also increases or is credited.
Usually, the bank needs the business to provide collateral for security purposes in case the loan is not paid. This can be a fixed or current asset which is frozen by the bank until the loan is paid. Also, interest is charged on the loan based on the length of time for which the loan is taken. The expense account Interest is debited.
Money or fixed assets borrowed from a person or business is a lender’s loan and the agreement can be made for long term or short term. The period of the loan determines which heading it is placed under in the balance sheet. When cash or cheque is received from a lender, the current asset account Cash or Bank increases or is debited and the liability account Lender’s Loan also increases or is credited.
The lender may be a financial institution that offers loans with no collateral but high interest rates. It may be a supplier that offers a low interest loan to assist the business so as to benefit from greater sales in the long run. An owner, family member or friend can be a lender who may or may not expect interest but wants to help the business in need.
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The business can utilise fixed assets such as machinery, equipment and furniture before fully paying for them with a plan called Hire Purchase and the agreement can be made for long term or short term. The fixed asset account increases or is debited and the liability account Hire Purchase also increases or is credited. The period of the loan determines which heading it is placed under in the balance sheet.
A down payment for the item is made and its cost added to interest is spread over an agreed period. The business enjoys the benefit of paying small monthly installments until the final payment is made and ownership is obtained. The downside is that the total payments after the period turns out to be far more expensive than the original cost.
Some liabilities are identified as long term and can be easily placed under this heading in the balance sheet. These accounts finance non-current assets in the business and are paid for using current assets.
A financial institution, business or person can provide an investor’s loan to the business with the expectation of having a stake in the profits. When the cash or cheque is received from the investor, the current asset account Cash or Bank increases or is debited and the liability account Investor’s Loan also increases or is credited.
The amount borrowed is usually large to support the purchase or development of capital expenditure. The business may use an investor’s loan to finance land, buildings, vehicles, roads or major projects. The investor analyses the business plan carefully and proposes or accepts an offer that involves investing a certain amount of money for part ownership of the business. Usually, negotiation takes place before an agreement is settled.
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A mortgage is an agreement between the business and a lender that gives the lender the right to take the property if the business fails to repay the money it has borrowed plus interest. The maximum allowable length for a mortgage is 25 years although in the past it was obtained for up to 40 years.
The fixed asset account increases or is debited and the liability account Mortgage also increases or is credited. In the balance sheet, a mortgage is placed under the heading long-term or non-current liabilities while the asset that it is financing falls under fixed or non-current assets.
Debenture loan is an unsecured long-term liability that is given by lenders to companies with good credit and reputation. It is usually issued by corporations and governments to raise capital or funds. Some debentures can convert to equity shares while others cannot.
The fixed asset account increases or is debited and the liability account Debenture loan also increases or is credited. It falls under non-current liabilities in the balance sheet. In the year when it is due to be repaid, it becomes a current liability.
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Some liabilities are identified as short term and can be easily placed under this heading in the balance sheet. These are adjusting accounts that complete the double entry for transactions for assets, income and expenses in which the business owes something.
When a customer pays cash for goods in advance, the account is Prepaid revenue and is a current liability to the business. Even though the money has been received, it has not yet been earned since the goods are owed to the customer.
When the cash is received from the customer, the current asset account Cash increases or is debited. The current liability account Prepaid revenue also increases or is credited.
In another period when the goods are finally delivered to the customer, the income account Sales increases or is credited. The liability account Prepaid revenue decreases or is debited. This debit closes off the Prepaid revenue account and completes the transaction.
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When the business uses services of providers but has not paid for it as yet, this is Accrued expense and a current liability. Even though the money has not been paid, the expense has been incurred.
The expense account increases or is debited. The liability account Accrued expense also increases or is credited.
In another period when payment is made to the service provider, the asset account Cash decreases or is credited. The liability account Accrued expense also decreases or is debited. This debit closes off the Accrued expense account and completes the transaction.
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Creditors and Accounts payable
Creditors and Accounts payable are current liabilities that represent money the business owes. Creditors are suppliers from which the business purchased goods or services. When the business is invoiced for the goods, the suppliers are Accounts payable.
When the business receives goods from a supplier on credit, the expense account Purchases increases or is debited. Accounts payable also increases or is credited.
Similarly, when the business buys assets on credit through short-term loans or hire purchase, the asset account increases or is debited. Accounts payable also increases or is credited.
In another period when the business pays its debt, the current asset account Cash decreases or is credited and Accounts payable also decreases or is debited. This debit closes off the Accounts payable account and completes the transaction.
When the business withdraws more money than it owns in the bank, it is called a Bank overdraft and is a current liability as the business owes the bank. The Bank account has a negative figure or a credit balance in the ledger account.
In the balance sheet, Bank overdraft falls under current liabilities and Bank is no longer listed under the current assets heading. When the business deposits cash and cheques into the bank, the negative figure eventually turns positive or the Bank account has a debit balance. In the balance sheet, Bank appears under current assets and Bank overdraft is removed from current liabilities.
In company accounts, the business has to pay its shareholders cash dividends which is a current liability. When a cash dividend is declared by the board of directors, debit the Retained Earnings account and credit the Dividends Payable account, thereby reducing equity and increasing liabilities.
The business must meet two criteria. First, there must be sufficient cash on hand to fulfill the dividend payment. Second, the company must have sufficient retained earnings as in it must have enough residual assets to cover the dividend such that the Retained Earnings account does not become a negative or debit amount upon declaration.
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