Expenses and Liabilities

expensesExpenses and liabilities should not be confused with each other.

One is listed on a company’s balance sheet, and the other is listed on the company’s income statement. Expenses are the costs of a company’s operation, while liabilities are the obligations and debts a company owes.

Expenses are the cost of operations that a company incurs to generate revenue. Unlike assets and liabilities, expenses are related to revenue, and both are listed on a company’s income statement. In short, expenses are used to calculate net income. The equation to calculate net income is revenues minus expenses. For example, if a company has more expenses than revenues for the past three years, it may signal weak financial stability because it has been losing money for those years.

Expenses consist of the economic costs a business incurs through its operations to earn revenue. Businesses are allowed to write off tax-deductible expenses on their income tax returns to lower their taxable income and thus their tax liability. Common business expenses include payments to suppliers, employee wages, factory leases and equipment depreciation, but the Internal Revenue Service has strict rules on which expenses business are allowed to claim as a deduction.

Deductible Business Expenses

According to the IRS, to be deductible, a expenses must be both ordinary and necessary. Ordinary means the expense is common or accepted in that industry, while necessary means the expense is helpful in the pursuit of earning income. Business owners are not allowed to claim their personal, nonbusiness expenses as business deductions.

Recording Expenses

Accountants record expenses through one of two accounting methods: cash basis or accrual basis. Under cash basis accounting, expenses are recorded when they are paid. For example, if a business owner schedules a carpet cleaner to clean the carpets in his office and the cleaner invoices the company for the service, a company using cash basis records the expense when it pays the invoice. Under the accrual method, however, expenses are recorded when they are incurred, and to continue with the above example, the business accountant records the carpet cleaning expense when the company receives the service.

Liabilities

A liability is a company’s financial debt or obligations that arise during the course of its business operations. Liabilities are settled over time through the transfer of economic benefits including money, goods or services. Recorded on the right side of the balance sheet, liabilities include loans, accounts payable, mortgages, deferred revenues and accrued expenses.

Liabilities are a vital aspect of a company because they are used to finance operations and pay for large expansions. They can also make transactions between businesses more efficient. For example, in most cases, if a wine supplier sells a case of wine to a restaurant, it does not demand payment when it delivers the goods. Rather, it invoices the restaurant for the purchase to streamline the drop off and make paying easier for the restaurant. The outstanding money that the restaurant owes to its wine supplier is considered a liability. In contrast, the wine supplier considers the money it is owed to be an asset.

Businesses sort their liabilities into two categories: current and long-term. Current liabilities are debts payable within one year, while long-term liabilities are debts payable over a longer period. For example, if a business takes out a mortgage payable over a 15-year period, that is a long-term liability. However, the mortgage payments that are due during the current year are considered the current portion of long-term debt and are recorded in the short-term liabilities section of the balance sheet.

Ideally, analysts want to see that a company can pay current liabilities, which are due within a year, with cash. Some examples of short-term liabilities include payroll expenses and accounts payable, which includes money owed to vendors, monthly utilities, and similar expenses. In contrast, analysts want to see that long-term liabilities can be paid with assets derived from future earnings or financing transactions. Debt is not the only long-term liability companies incur. Items like rent, deferred taxes, payroll and pension obligations can also be listed under long-term liabilities.

The Relationship Between Liabilities and Assets

Assets are the things a company owns, and they include tangible items such as buildings, machinery, and equipment as well as intangible items such as accounts receivable, patents or intellectual property. If a business subtracts its liabilities from its assets, the difference is its owner’s or stockholders’ equity. This relationship can be expressed as assets – liabilities = owner’s equity. However, in most cases, this equation is commonly presented as liabilities + equity = assets.

 


 

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