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Liabilities and Expenses - How to demarcate?

accounting expences finance liabilities liability workingcapital Aug 01, 2022

If you are studying basic accounting concepts, one of the first problems you are going to have will be with identifying and distinguishing between expenses and liabilities. Today, I will try to explain, simply, how to understand the difference between expenses and liabilities.

Let us consider a simple example. Assume John is a full-time student studying in Toronto and he works for Alo restaurants on a part-time basis. Assume that Alo pays John $2,400 every month for his work and he is being paid on the 30th of every month.

On the first day of the month, if the owners of Alo look at their liabilities (what Alo owes others, or what Alo should pay others), John's name will appear. This is because Alo needs to pay John $2,400 by the 30th of the month. This means Alo is obligated to pay or is liable to pay John's salary. Hence, John's salary is a liability.

Now let's assume that it is the last day of the month and all employee salaries are settled. If reconsider John's salary, it is not a liability to Alo anymore. As the salary has been paid, the liability has been settled. Therefore, John's salary is no longer a liability.

However, to settle John's salary and settle the liability, Alo has had to transfer $2,400 from the company bank account to John's personal bank account. This means Alo has expended $2,400 it owned to settle the liability it had towards John. Hence, on the last day of the month, once the salaries are settled, John's salary is an 'expense' but not a 'liability'.

The generalization of the above understanding can be summarized as below;

An obligation before settling it financially is a 'Liability'
An obligation after settling it financially is an 'Expense'

This is why the date of the balance sheet is so important. As of the balance sheet, obligations that have not been financially settled will be shown as liabilities. All obligations that have been financially settled from the last balance sheet date are now transferred to the 'expenses' section in the income statement.

Expenses lower liabilities. However, they worsen the company's working capital position. Simply put, when a company's payables increase, its working capital of it decreases. It means the company's cash remains in the company for a long time. Payables are the main component of a company's liabilities. In fact, salaries are also a part of payables. So, when the payables increase (meaning, when the liabilities are not settled and when they keep on piling), the cash position of the company grows. As cash needs to be expended to settle liabilities (such as payables), not settling them will allow companies to have huge cash balances. When liabilities are settled, the company's cash position comes down, and hence the working capital worsens. Although liabilities such as employee salaries need to be settled on time without failing, to manage their working capital, companies most of the time deprioritize settling many liabilities they have.

A detailed version of this article with example calculations can be obtained under the paid version. To obtain paid membership, simply write to [email protected].

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