Liabilities vs. expenses: How they differ and how to manage them effectively

Small businesses sometimes struggle with the difference between their expenses and liabilities. It’s important to understand and manage these two metrics effectively so you don’t create an unnecessary burden on financial management. Improper handling can make financial planning and analysis a lot more difficult.

‍

In this article, we’ll clarify the difference between expenses and liabilities in accounting, explain how they arise, and discuss the insights they provide into a company’s financial performance.

Liability vs. expense: Key difference

First off, liabilities are not expenses. They have different characteristics and reside in different financial statements.

‍

Expenses are the costs of your company’s operation, while liabilities are the obligations your company owes. In practice, this means expenses are included on your company’s income statement, and liabilities are listed on your balance sheet.

‍

We’ll show examples of how they work within your income statement and balance sheet when we get into more detail. First, let’s define liabilities vs. expenses and review some examples of each.

What is a liability?

A liability is an obligation your company must meet in the future. One common example is the payments your company needs to make on your outstanding debt. Correctly calculating liabilities is crucial to conducting accurate financial planning and regulatory reporting.

Types of liabilities

Current liabilities

A current liability is not an expense. You’d list these on your balance sheet, and they’re often paid with current assets, which include cash and cash equivalents, marketable securities, and receivables. Current liabilities include payables, other short-term obligations, and short-term debt (i.e., debt maturing within a year).

‍

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:

‍

• Cash
• Investments
• Inventories
• Accounts receivable
• Prepaid expenses
• Liquid assets

‍

Long-term or noncurrent liabilities

These consist mainly of long-term debt maturing in more than one year. You’d usually pay these out of fixed assets.

‍

Here are some examples of long-term liabilities:

‍

• Bonds and subordinated debt
• Mortgage debt
• Long-term loans and other notes payable 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)

Contingent liabilities

Contingent liabilities are often a source of confusion. These are business 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 pending lawsuit.‍

‍

Under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) accounting rules, your company must record contingent liabilities on your balance sheet if you can reasonably estimate the size and probability of the liability.

How to record liabilities in 4 steps

To record liabilities, look at all the items on your company’s general ledger, which tracks all the obligations you’re due to pay in the future, then take the following steps:

1. Classify transactions

Determine the classification of each transaction. To illustrate how, we’ll use some fictional transactions from Ford Motor Company as examples of liabilities. Note that some transactions generate both current and long-term liabilities, as with the bond issue we’ll review below 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% 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.
  

2. Estimate liabilities

Estimate the size and probability of any contingent liabilities, such as the outcome of a lawsuit or regulatory investigation. If you can reasonably estimate the probability and size of the liability account, put it on your balance sheet.

‍

Depending on when you’d likely need to pay it, classify it as a current or long-term liability. If you can’t estimate the probability and size of the liability, your company only has to mention it in the notes that accompany your balance sheet.

3. Calculate liabilities

To calculate your liabilities, add up your current and long-term liabilities separately, and put the separate totals on the balance sheet.

4. Record liabilities

Sum the current and long-term liabilities and put the total liabilities figure on your balance sheet.

What is an expense?

An expense is a cost incurred to generate business revenue. Managing business expenses is key to improving net income, or earnings—in other words, your company’s bottom line.

‍

You report expenses on your company’s income statement, or profit and loss (P&L) statement. There’s often confusion about whether expenses are assets or liabilities. Let's explore this question in more detail below.

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. COGS includes the cost of raw materials, direct labor costs, and the overhead costs associated with production.

Selling, general, and administrative (SG&A) expenses

SG&A expenses 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:

‍

• Advertising
• Amortization
• Bad debts
• Bank charges
• Charitable contributions
• Commissions
• Contract labor
• Depreciation
• Dues and subscriptions
• Employee benefit programs
• Insurance
• Interest payable
• Legal and professional fees
• Licenses and fees
• Miscellaneous
• Office expense
• Payroll taxes
• Postage
• Rent
• Repairs and maintenance
• Supplies
• Telephone
• Travel
• Utilities
• Vehicle expenses
• Wages

How to record expenses

Calculating expenses is generally easier than calculating liabilities since these are costs you already incurred during the reporting period. However, assembling and managing 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 eliminates cumbersome expense reports and integrates with your accounts payable, accounts receivable, and treasury management systems.
2. Calculate the cost of goods sold. Add up the materials, wages, and other costs that went toward creating the products or services your company sold.
3. Add up the SG&A expenses listed above.
4. Enter the COGS and SG&A expenses into your income statement.

‍

Ready to take control of your finances?

Learn about Ramp’s pricing
plans and start saving today.

Get started for free

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 for as long as possible.

‍

If their liabilities grow too quickly, they won’t be able to raise growth capital when they need it. If their expenses greatly outrun their revenues, they’ll simply run out of operating capital, meaning they’ll have to turn to dilutive rounds of venture financing or go out of business.

Accrued liabilities and expense payments

There is one area where liabilities and expenses are close to overlapping: accrued liabilities. Accrued liabilities are expenses your business incurred during a given period for which you have not yet been billed. You’d list these as current liabilities on your balance sheet.

‍

Accrued liabilities appear similar to accounts payable. However, accounts payable have been billed to your company, while accrued liabilities have not.

‍

There are two types of accrued liabilities:

‍

1. Routine or recurring liabilities: These are normal parts of the business operations that your company can always expect to face, such as payroll expenses
2. Infrequent or nonroutine liabilities: 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

The importance of timely payment

Liabilities, accrued liabilities, and expenses must all be paid on time.

‍

If you don’t pay expenses on time, you risk vendors shutting off crucial services and mission-critical supplies. It can also damage your business credit rating and your reputation as a reliable vendor. In the worst case, it can shift an economic expense into a legal liability if the vendor decides to sue.

‍

Keep in mind that you generally can’t defer an expense. If you have a net 30 or net 90 payment agreement, you must stick to the terms unless the vendor is willing to offer you financing. Only in the case of accrued liabilities, which are expenses for which you have not yet been billed, can you defer an expense.

‍

Not paying liabilities on time risks having lenders exercise debt covenants, seize assets, and, in worst-case scenarios, declare you in default and seize your assets.

Explore how Ramp streamlines expense management

Ramp is the finance automation platform designed to save your business time and resources. With Ramp, you get corporate cards, expense management, bill payments, accounting automation, and reporting—all in one easy-to-use platform. Businesses that use Ramp save an average of 5% annually and close their books faster each month.

‍

By providing detailed insights and real-time visibility, Ramp simplifies the process of tracking and managing business liabilities. Whether it's short-term obligations like payroll and accounts payable or long-term commitments such as bonds and mortgages, Ramp offers a modern approach to guarantee that you meet your financial responsibilities on time.

‍

See how Ramp can help you manage your business finances.