Assets are important, but so are liabilities. The latter, however, needs to be handled particularly carefully. Read on to find out what liabilities are, how they integrate into all companies’ finances, and why they are vital for businesses through practical examples.
What Are Liabilities
Liabilities are what the company owes as of the date of the balance sheet. The liabilities of Wasslak are shown at the top of its balance sheet.
Samy gives Abdullah some examples of liabilities:
- the loan he got from his uncle (Notes Payable or Loan Payable),
- the interest on the loan he owes to his uncle (Interest Payable),
- the amount he owes the supply store for items he bought on credit (Accounts Payable), and
- the wages he owes an employee falls (Wages Payable).
Read more about Understanding Company Assets On The Balance Sheet.
Another liability is money received in advance before it was earned. For example, say Wasslak strikes a deal that the customer will pay SAR 600 upfront in exchange for the delivery of 30 packages each month for six months. According to this, Wasslak gets SAR 600 on December 1 for deliveries that will be made between December 1 and May 31.
Wasslak had SAR 600 in cash on hand on December 1 but has not yet earned that SAR 600. The company won't record this as income until it delivers the packages of the deal. So on December 1, Wasslak will have to report that its Cash asset went up by SAR 600, but it will also have to report that it owes SAR 600, because it has to send out SAR 600 worth of packages within six months to complete the deal.
The SAR 600 received on December 1 is a liability account called "Unearned Revenue" (or Deferred Revenues, Customer Deposits, etc.). As the 30 packages are delivered each month, Wasslak will earn SAR 100. The above means that SAR 100 will move from the Unearned Revenue account to the Service Revenues account each month. So, as Wasslak keeps up with the agreement and delivers packages, its monthly liability goes down by SAR 100, and its monthly income statement goes up by SAR 100.
Liabilities And Stockholder Equity
If the company is a corporation, Stockholder Equity is the third part of the balance sheet. If one person owns the business, this part is called Owner's Equity.
Simply put, the difference between the number of assets and liabilities is the amount of stockholder equity. Because of this, accountants often call Stockholder Equity the difference between assets and liabilities.
Since the corporation's assets are listed at their cost or less (not their market value), it's important not to confuse the amount of Stockholder Equity with the corporation's market value. That's why it's the wrong choice of words to call Stockholders' Equity the "net worth" of the company. Instead, to find out what a company is worth, you should hire a professional who knows how to value businesses.
In the Stockholder Equity section, you may see accounts like:
- Common Stock
- Paid-in Capital
- Preferred Stock
- Retained Earnings, etc.
When the company issues shares of stock for cash, the account Common Stock will go up. However, when the company makes a profit, retained earnings will go up. Lastly, when the company has a net loss, there will be a drop in the corresponding entry.
When the company generates more revenue, Stockholder Equity will automatically go up. Vice versa, expenses will bring Stockholder Equity down. The above essentially shows how a company's balance sheet and income statement are linked.
Sample Transaction Samy shows Abdullah how a transaction works. For example, on December 2, Wasslak wrote a check for SAR 14,000 to buy a used delivery van. Cash and Vehicles are the two accounts in question. When the check is written, the accounting software will automatically update these two accounts. Samy tells Abdullah what is going on inside the program. As the company pays SAR 14,000, the Cash account is credited. We only need to find the best account to debit which, in this case, will be Vehicles. The entry will look something like this:
After the vehicle transaction is added to the balance sheet, it will look like this: Wasslak Inc. Balance Sheet December 2, 2022 Total assets amount to SAR 20,000, out of which SAR 6,000 is in a cash account, and SAR 14,000 belongs to vehicles. The liabilities and stockholder equity turns out to be SAR 20,000. It is represented by common stock. With all considered, the accounting equation and the balance sheet are still in balance:
Assets = Liabilities + Stockholder Equity
SAR 20,000 = SAR 0 + SAR 20,000
All in all, this balance sheet shows that Cash went down by SAR 14,000, and Vehicles went up by the same amount. Liabilities and stockholder equity did not change because they were not involved.