obligation

What is a liability?

liability is an obligation that the company has to another party. Typically when we think of liabilities, we think of accounts payable or notes payable, but there are many other liabilities that a company can have to other people or entities.

Whenever a company owes money or services to another party, there is a liability. A liability must be recorded if the company can estimate the amount of the liability and is reasonably sure that the liability is owed.

Liabilities have a normal credit balance. When a liability increases, we credit the account. When a liability is paid or an obligation is fulfilled, either in whole or in part, the account is debited.

What is a current liability?

Current liabilities are liabilities that are due in less than one year or one operating cycle. The most notable liability that most people think of when they think of current liabilities is accounts payable. There are however many other accounts qualify as current liabilities.

Accounts payable is a current liability used for normal day-to-day bills. Some textbooks will argue that accounts payable should only be used for the purchase of inventory and supplies, but in my experience, accounts payable is used for all routine bills that must be paid. This would include supplies, inventory, utility bills, telephone bills, and other bills which the company plans to pay at a later date.

Any other current amount owed must be placed in its own payable account. This includes salaries payable, taxes payable, interest payable and any other obligations a company would have.

Recording and paying accounts payable

When a company purchases something and does not pay for it at the time of purchase, a payable is created.

Example #1

On January 15, KLI, LLC purchases $1,500 worth of supplies on account, terms n/30.

In this example, the company is purchasing supplies but has not paid for them yet. How do we know the company has not paid for them? There are a few key things to look for. First, the statement does not use the word “paid.” “Paid” always indicates that cash is involved. Since cash is not involved, We know we have not paid for the purchase.

Second, we see “on account” in the statement. On account indicates either Accounts Payable or Accounts Receivable. When we see on account, we should ask “Are we going to pay cash later or receive cash later?” If we are going to pay cash later because we purchased something, we have Accounts Payable.

If you do not have either “paid” or “on account”, there is one additional give away in the transaction. If you see terms, the purchase was made on account. Payment terms, such as n/30, are only included if the transaction has not been paid for. If the transaction had been paid for, we wouldn’t need to know that the bill must be paid within 30 days.

Here is the journal entry for the transaction:

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Example #2

On February 10, KLI, LLC paid for the supplies purchased on January 15.

In this transaction, we are paying for the supplies previously purchased. Be careful when recording a transaction like this. Many people studying accounting get this one wrong the first few times they try it.

The transaction states that the company paid for something. That is one of the keywords we discussed above. When we see “paid” in the transaction, Cash is involved.

What did the company actually pay for? We are told to refer back to the transaction on January 15. In that transaction, we recorded Supplies and Accounts Payable. Are we purchasing more supplies or are we paying off the Accounts Payable? The transaction indicates that we are paying for supplies that were previously purchased, not purchasing more supplies.

Let’s see if that fits into our journal entry. We know that Cash will be a credit. Does it make sense to debit Accounts Payable? Since we are paying off what we owed, we are fulfilling the obligation. We want the balance in Accounts Payable to decrease so we would debit Accounts Payable.

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Lots of different liabilities

Over the next few posts, we will be covering a number of new current and long-term liabilities. All of these liabilities follow the same rules as described above. When classifying a liability ask yourself if the company has an obligation to anther party. If the answer is yes, then you have a liability.

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