When recording business transactions, how do you know when something is a liability or an expense? Are they technically the same thing?
Knowing the difference between liabilities and expenses is crucial for accurate financial reporting and informed decision-making.
In this guide, we’ll define both liabilities and expenses and outline the key differences between these two financial terms.
What are liabilities?
Liabilities are a financial obligation. They may also be referred to as debts, representing what a company owes at any given time to lenders, tax agencies, suppliers, employees, and others.
Liabilities are reported on the balance sheet against a company’s assets and equity. Companies need visibility into their liabilities to understand the future payments they will need to make. This helps to ensure liquidity and remain in good standing with external parties.
Types of liabilities
Liabilities can be classified as current, non-current, or contingent. This classification determines when repayment is due, which can impact a company’s financial planning decisions.
Current liabilities
A business may have current (short-term) liabilities, which means repayment is due within one year or less.
These are reported separately on the balance sheet from non-current liabilities to provide clarity around the company’s obligations over the coming year. They are often covered by short-term assets, like cash, accounts receivable, and inventory.
Here are some common examples of current liabilities:
- Accounts payable
- Wages payable
- Income taxes payable
- Interest payable
- Dividends payable
- Short-term loans
- Unearned revenue
Non-current liabilities
There are also non-current (long-term) liabilities on the balance sheet. These are obligations that have a repayment period longer than one year.
Non-current liabilities often stem from long-term investments, like loans used to purchase new equipment or machinery for the business.
Here are some of the non-current liabilities that may appear on the balance sheet:
- Long-term loans
- Notes payable
- Mortgages
- Bonds
What are expenses?
Expenses are costs the business incurs in the course of doing business. They support revenue generation and are reported on the income statement. Expenses are reported in the same period that they’re incurred, regardless of whether the company has made a payment.
Expenses directly impact a company’s net income. As such, expenses are a key lever that businesses can use to influence profitability. All things considered equal, higher expenses will mean lower profits, and vice versa.
Some expenses are also tax-deductible, meaning accurate tracking helps businesses with tax planning and optimization.
Types of expenses
Expenses are typically divided into a few main categories: fixed and variable expenses and operating and non-operating expenses.
Importantly, these classifications are not exclusive, meaning that an expense can be both a variable and an operating expense.
Fixed vs. variable expenses
An expense may be classified based on its relation to production or activity levels. A fixed expense does not change with varying activity levels. It stays the same from period to period, making it more predictable.
A common example of a fixed expense is office rent, which costs the company the same amount each month, regardless of activity levels.
On the other hand, a variable expense does vary depending on activity levels. An example of this might be the wage expense for hourly employees. In other words, this expense would increase during times of high production volumes, and decrease in slower periods.
Operating vs. non-operating expenses
Alternatively, expenses may be operating or non-operating, depending on how closely related they are to core business activities.
Operating expenses are incurred to support day-to-day business operations. This includes the cost of goods sold (COGS) and selling, general, and administrative (SG&A) expenses, such as:
- Raw materials
- Direct labor costs
- Equipment maintenance costs
- Facility rent
- Utilities
- Shipping and storage costs for finished goods
Non-operating expenses are costs the business incurs that are not directly related to the core business operations. They are often irregular in nature. Some examples include:
- Interest on loans
- Losses from an asset sale
- Asset write-downs/impairments
What is the difference between liabilities and expenses?
Despite the similarities, liabilities and expenses are two distinct financial concepts. Here’s a closer look at how the two differ.
Impact on financial statements
One of the key differences between liabilities and expenses is how they are reported on a company’s financial statements.
As mentioned above, expenses are reported on the income statement, also known as the profit-and-loss statement. Expenses directly impact a company’s net income in the current period.
In contrast, liabilities are recorded on the balance sheet, representing future cash outflows. The balance of total liabilities influences the accounting equation, where a company’s assets equal its liabilities plus equity.
Put differently, when the balance of total liabilities goes up, its equity decreases to keep the equation in balance.
Timing of recognition
There are some differences in the recognition timing of liabilities and expenses. Expenses are recognized in the period they are incurred to generate revenue, regardless of when cash is exchanged. This is known as the matching principle.
Liabilities, on the other hand, are recognized when the company takes on a new financial obligation from an external party.
Real-world examples of liabilities and expenses
Let’s say in January, a company pays $12,000 for insurance for the year. This is considered a prepaid expense, which is an asset. The expense is not recognized until the period in which it is consumed.
So, the company will record an insurance expense of $1,000 each month, as the insurance coverage is used.
Additionally, the company receives an invoice from a supplier for $2,500 on October 10 that is not due until November 10. When the bill arrives, the team will record it as an expense and an increase in accounts payable to represent the future obligation.
The relationship between liabilities and expenses
As showcased in the above example, liabilities and expenses are closely related. It’s common for expenses to also start off as a liability, in the case that the company has not yet made a cash outflow for the transaction.
Then, when the company pays cash for it, the liability goes away. No new expense is recorded, since this was already done when it was incurred.
Best practices for managing liabilities and expenses
Strategic financial management requires teams to diligently track and control liabilities and expenses. Here are some helpful tips to get started:
Use accounting software to track transactions
Timely and accurate updates of the company’s accounting records help teams adhere to the expense matching principle and properly manage liabilities.
Accounting software that syncs with bill pay solutions and other financial platforms enables automated journal entries and transaction verification with a two- or three-way sync. In turn, this reduces the team’s reliance on error-prone manual data entry.
Focus on cash flow management
Liabilities should come into consideration for future budgeting decisions and cash flow management.
Again, the total amount of liabilities represents the company’s future financial obligations. Teams should be prepared to make these payments to prevent cash shortages.
Where possible, teams should negotiate for more favorable payment terms, like net 60 terms instead of net 30, to give themselves more leeway to pay off liabilities.
Implement approvals workflows
Strong internal controls can also help a team manage liabilities and expenses. This might start with a detailed expense policy, outlining what’s considered an approved business expense to avoid needless purchasing.
Further, it can be useful to implement approval workflows for certain purchases, like requiring all transactions over a certain dollar amount to receive prior approval.
Simplify expense tracking with BILL
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Accountants can set custom budgets and spending rules, track spending in real-time, and review and approve transactions on the go.
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Frequently asked questions
What is the difference between liabilities and expenses?
The main difference between liabilities and expenses is that liabilities are debts, representing what the company must still pay. Expenses are costs the business incurs to generate revenue.
How do liabilities impact a company's financial statements?
Liabilities are reported on a company’s balance sheet. They help businesses understand how much they will need to pay to external parties in the future.
Are expenses considered liabilities?
No, expenses are not considered liabilities. They are two distinct financial terms. An expense is a cost that a business incurs to generate revenue. They are reported on the income statement, impacting net profits. On the other hand, liabilities are financial obligations that represent what a business owes to others. Liabilities are recorded on the balance sheet. It’s important to note that an expense that a business incurs, but has not yet paid for, can become a liability. This includes accrued expenses.
What are some examples of liabilities and expenses?
Some common examples of liabilities include accounts payable, wages payable, loans, and mortgages. On the other hand, some common types of expenses include rent, utilities, wages, and marketing costs.
What are the classifications of liabilities and expenses?
There are three main classifications of liabilities, including current (short-term), non-current (long-term), and contingent. Short-term liabilities are due within one year, non-current liabilities are due in over a year, and contingent liabilities are probable and can be reasonably estimated. Expenses can be divided into a few different categories, including fixed and variable expenses and operating and non-operating expenses.
