Small businesses often struggle to understand the differences between their expenses and liabilities. This is worrisome because, if they do not understand and manage these two metrics effectively, it will be an unnecessary burden to financial management, and will make financial planning and analysis very difficult.
In this article we will define liabilities and expenses, explain how they arise, and discuss the different types of insights they provide into a company’s financial performance and prospects.
Expenses and liabilities: key characteristics
First off, expenses are not liabilities. They have different characteristics and reside in different financial statements.
We will show examples of how they work within the income statement (expenses) and balance sheet (liabilities) when we get into more detail, but for the time being, here is a comparison of their key characteristics.
What is a liability?
A liability is an obligation that must be met in the future. One common example is the payments a company must make on its outstanding debt. Calculating liabilities correctly is crucial for business owners to conduct accurate financial planning and regulatory reporting.
Here is the portion of Ford Motor Company’s first-half 2022 balance sheet where it lists its assets and liabilities.
Types of Liabilities
These include payables, other short-term obligations, and short-term debt (defined as debt maturing within a year). They are often paid with current assets, which include cash and cash equivalents, marketable securities, and receivables.
Here are some examples of current or short-term liabilities:
· Accounts payable
· Accrued wages
· Accrued compensation
· Income taxes payable
· Unearned revenue
Here are some examples of current assets:
· Accounts receivable
· Pre-paid expenses
Long-term or non-current liabilities
These consist mainly of debt maturing in over one year. They are often paid for out of fixed assets.
Here are some examples of long-term liabilities:
· Bonds and subordinated debt
· Mortgage debt
· Bank loans and other senior debt of over one year in maturity
Here are some examples of long-term fixed assets:
· Property and equipment
· Other non-liquid assets
· Leasehold improvements
· Equity and other investments
· Accumulated depreciation (Negative Value)
These are often a source of confusion. They are liabilities that are probable, but not certain – in other words, the need to pay them is contingent on some event. A typical example of a contingent liability is the potential court award for a company being sued by shareholders or regulators.
Under US GAAP and IFRS accounting rules, companies must record contingent liabilities on their balance sheets if the size and probability of the liability can be reasonably estimated.
How to record liabilities in 4 steps
To record liabilities, look at all the items on a company’s general ledger, which keeps track of all obligations due to be paid in the future, then take the following steps:
Step #1: Classify transactions
Determine the classification of each transaction. Note that some transactions generate both current and long-term liabilities, as with the bond issue in example 2.
· Example 1: A $1 million payment Ford received in the current accounting period for a fleet of trucks to be delivered in the next quarter would generate both a $1 million asset categorized as “cash” and a $1 million liability under “deferred revenue” or “unearned revenue”.
· Example 2: If Ford issued $100 million in 10-year bonds yielding 10 percent a year, it would generate a $100 million asset categorized as “cash”. It would generate a $10 million current liability for the interest due in the next year. It would also generate a $100 million long-term liability characterized as long-term debt.
Step #2: Estimate liabilities
Estimate the size and probability of any contingent liabilities, such as the outcomes of lawsuits or regulatory investigations. If the probability and size can be “reasonably estimated”, put the liability on the balance sheet. Depending on when it would probably need to be paid, classify it as a current or long-term liability. If the probability and size cannot be reasonably estimated, the company only has to mention it in the notes that accompany the balance sheet.
Step #3: Calculate liabilities
Add up the current and long-term liabilities separately and put the separate totals on the balance sheet.
Step #4: Record liabilities
Sum the current and long-term liabilities and put the total liabilities figure on the balance sheet.
What is an expense?
An expense is a cost incurred to generate business revenue. Managing expenses is key to improving net income, or earnings – also known as the company’s bottom line.
Expenses are reported on a company’s income statement, also known as its profit and loss statement, or “P&L”.
Types of expenses
Expenses generally fall into two basic categories.
Cost of goods sold (COGS)
These are the actual costs involved in creating the products or services the company sells. On the Ford income statement, they are listed as “cost of sales”.
Selling, Administrative and Other Expenses
These involve all the other costs of running the business and must be managed carefully to ensure that revenues do not “leak out” through poor cost controls. These expenses can include:
· Bad Debts
· Bank Charges
· Charitable Contributions
· Contract Labor
· Dues and Subscriptions
· Employee Benefit Programs
· Interest Payable
· Legal and Professional Fees
· Licenses and Fees
· Office Expense
· Payroll Taxes
· Repairs and Maintenance
· Vehicle Expenses
How to record expenses
Calculating expenses is somewhat easier than calculating liabilities, since these are costs that have already been incurred during the reporting period. However, assembling your P&L is becoming more complex due to the growing need to track expenses effectively.
1. Track your expenses. Use a real time expense management system that integrates seamlessly with your accounts payable, accounts receivable, and treasury management systems, and eliminates cumbersome expense reports.
2. Calculate the cost of goods sold. Add up the materials, wage and other costs that went directly toward creating the product or services your company sold.
3. Add up the Selling, Administrative and Other Expenses listed above.
4. Enter the COGS and SAO Expenses into an income statement.
Why liabilities and expenses are important to startups
Liabilities and expenses are particularly important to startups, which often have negative cash flows or operate at a loss. These companies need to stretch their initial equity and any debt they can raise to last as long as possible.
If their expenses greatly outrun their revenues, they will simply run out of operating capital, meaning they will have to turn to dilutive rounds of venture financing or go out of business.
If their liabilities grow too quickly, they will be unable to raise growth capital when they need it.
Accrued liabilities and expense payments
There is one area where liabilities and expenses are close to overlapping. This is in the case of accrued liabilities.
Accrued liabilities are expenses incurred by a business during a given period, which it has not yet been billed for. They are listed as current liabilities on the balance sheet.
Accrued liabilities appear similar to accounts payable, which are expenses. However, accounts payable have been billed to the company, while accrued liabilities have not.
There are two types of accrued liabilities.
1. Routine/Recurring. These are normal parts of the business operations that the company can always expect to face, such as payroll expenses.
2. Infrequent/Non-routine. These are one-off purchases for which the company has not been billed.
Examples of accrued liabilities
Here are three classic examples of accrued liabilities from the Corporate Finance Institute:
1. Accrued interest expense: When a company owes interest on a loan but has yet to be billed by the lender.
2. Accrued wages: Employees have not been paid for work completed because their payroll period falls after the reporting date.
3. Accrued services: A supplier has provided a service but has yet to bill the customer.
Liabilities, accrued liabilities and expenses must all be paid in a timely manner.
Not paying expenses on time risks having vendors shut off crucial services and mission-critical supplies. It can also damage a company’s credit rating and its reputation as a reliable supply-chain vendor. Worst case, it can shift an economic expense into a legal liability, if the vendor decides to sue.
Not paying liabilities on time risks having lenders exercise debt covenants, seize assets, and in worse case scenarios, declare you in default and seize your assets.
Here are some links to some other blog articles we have published on these topics:
How Ramp helps startups with expense management
Ramp is the finance automation platform designed to save you time and money. With Ramp, you get corporate cards, expense management, bill payments, accounting automation & reporting — all in one easy-to-use and free solution. Businesses that use Ramp save an average of 3.3% annually and close their books 5 days faster than before.
Highly effective expense management is crucial for companies seeking to ensure poorly handled expenses today do not become tomorrow’s financial and even legal liabilities. Ramp can help your company avoid this risk.
Visit us today to learn more.