According to Merriam-Webster, a liability is defined as something for which one is legally responsible, particularly a financial debt or obligation. In accounting, the term also refers to an entry on a balance sheet that represents a debt owed by a business or individual.
Liabilities are typically categorized into two types: long-term liabilities, such as loans used to finance the purchase of property or major equipment, and current liabilities, which are obligations expected to be settled within one year. Long-term liabilities are generally tied to fixed assets and are updated annually in financial records, often as part of year-end tax adjustments to reflect changes in principal and interest expense.
While it may be tempting to avoid tracking current liabilities on your balance sheet, doing so can lead to missed payments and unnecessary penalties or interest charges. Maintaining accurate records of current liabilities ensures that obligations are met in a timely manner and also signals to stakeholders that the business is financially responsible and well-managed.
Liability accounts naturally fluctuate in balance. When payments are properly made, current liabilities should eventually reduce to zero. If they do not, or if they fall below zero, it may indicate an issue such as an overpayment, a failed or returned transaction, or a missed payment due to operational oversights (e.g., a bookkeeper being on leave). In some cases, payments set on autopay may continue even after the obligation has been fulfilled. Additionally, liabilities owed to government entities may not be flagged until months later, when penalties and interest have already been assessed.
Common Scenarios for Using Current Liability Accounts
1. Payroll Liabilities
After processing payroll, gross wages and the employer’s share of taxes should be recorded as expenses. However, additional amounts—such as federal withholdings, Social Security, Medicare, insurance premiums, retirement contributions, and child support deductions—must also be accounted for. These amounts, both employee- and employer-paid, should be recorded in a payroll liability account until the payments are remitted to the appropriate agencies.
2. Loans from Private or Informal Sources
If your business has borrowed funds from a family member or informal investor who does not send invoices, tracking the loan in a liability account on the balance sheet allows you to monitor repayments efficiently. Each payment reduces the outstanding balance and offers a clear record of repayment activity.
3. Accounts Payable
If your business manages vendor payments in batches or chooses to make partial payments, using an accounts payable liability account is essential. This provides visibility into total outstanding obligations and helps manage cash flow more effectively. Reviewing the balance sheet periodically allows you to determine which vendors are due and whether partial payments are necessary.
4. Intercompany Transfers
For businesses managing multiple entities, it is common to transfer funds between companies. These amounts should be recorded in "Due To" or "Due From" current liability or asset accounts. These intercompany accounts should mirror each other across entities to ensure accuracy and transparency in financial reporting.
While balance sheet accounts can be more complex to manage than those on the profit and loss statement, they are essential for maintaining accurate and actionable financial records. With the right setup and guidance, they provide significant value and support sound financial decision-making.