A liability is an obligation that a business has to its suppliers or its customers. Liabilities are usually monetary in nature. However, they can also consist of a payment in-kind. This article will explain everything you should know about liabilities in your day-to-day business. We will focus specifically on the business application of the term “liabilities.”

What’s in this article?

• What are liabilities?
  
• How do liabilities come about?
  
• Where to find liabilities on the balance sheet
  
• Liabilities explained: Examples from day-to-day business operations
  
• What are short-term and long-term liabilities?
  
• What is the difference between creditors and debtors?
  
• What is the difference between liabilities and provisions?
  

What are liabilities?

When it comes to a balance sheet, liabilities are the obligations of a business toward its creditors. These obligations can be of contractual nature—such as the purchase of goods by invoice—or of public law nature, such as the payment of taxes. The most important creditors are suppliers, credit institutions, and the tax office. Liabilities can include cash payments as well as payments in-kind.

Business-related liabilities at a glance

The following liabilities are relevant to the business’s balance sheet:

• Bank loans (i.e., liabilities that the business has toward credit institutions)
  
• Deliveries of goods from suppliers (i.e., liabilities that result from deliveries and services to the business)
  
• Group liabilities (i.e., liabilities that the business has toward associated businesses)
  
• Employee liabilities (i.e., liabilities that the business has toward its staff, covering areas such as fees, salaries, and legal expenses)
  
• Tax liabilities (i.e., liabilities such as tax owed by the business, as well as liabilities that arise from value-added tax or withheld payroll tax that the business has to pay on behalf of a third party)
  

How do liabilities come about?

Liabilities always come about when a debtor has not yet provided the agreed compensation for a service provided by a creditor that the debtor has already received. Therefore, liabilities are also called debts—even though they do not necessarily indicate that the business carries any debt, whether overindebted or otherwise.

There are three conditions required for liabilities to arise:

• A supplier, otherwise known as a creditor, has already provided an agreed service.
  
• An agreement was made that the business would compensate the creditor for the service provided. This usually takes the form of a monetary payment.
  
• The agreed compensation is still outstanding. Provided the business has not yet fulfilled its obligation to provide compensation, it is considered to be a debtor.
  

As a result, liabilities do not arise if the business provides its compensation at the same time as—or immediately after—the creditor provides its services or goods.

To ensure that liabilities can be differentiated from everyday business risk, you should check whether the following three features apply when potential liabilities arise:

• The compensation behind the liabilities must be enforceable. In practice, this means that creditors can enforce their claim to the compensation in a court of law.
  
• Its fulfillment must lead to an asset reduction, also known as encumbrance. This means that any future expenses incurred to fulfill the obligation are considered to be deductible.
  
• The compensation must be quantifiable. This applies to both the amount and the due date. This means that any economic burden resulting from the compensation can be defined and assessed on an individual basis.
  

Where to find liabilities on the balance sheet

A business’s financial situation can be outlined in a financial report any time. This report is also called a balance sheet. A balance sheet always contains two sides: assets and liabilities. The regulations governing the structure of the balance sheet are outlined in Section 266 of the Commercial Code (Handelsgesetzbuch, or HGB).

The business’s assets sit on the assets side. This includes all assets used by the business to carry out its activities. For example, these include so-called fixed assets such as real estate, machinery, and patents. In the long term, the business can use these assets to generate income. So-called current assets are also considered assets. This includes inventory, receivables, and cash. The business uses these items in the short term to finance its ongoing operations.

The business’s equity sits on the liabilities side of the balance sheet. This includes all equity—ranging from share capital and retained earnings to contributions from shareholders. In addition to equity, debt also belongs to the liabilities side of the balance sheet. These include liabilities and provisions.

It is important that both sides of the balance sheet must be balanced. Furthermore, the assets must correspond to the capital.

The balance sheet is a significant document for the business. It is also key for any parties that may have invested in the business, or provided loans or other financial services. Its importance stems from the invaluable insight it provides into the business’s financial situation, and the fact that it answers—among other things—the following question: does the business carry debts, and if so, is it in a position to meet its liabilities?

Liabilities explained: Examples from day-to-day business operations

A business can encounter different liabilities during the course of its day-to-day operations. For example, let’s say you run a marketing agency that is legally registered as a limited partnership:

1. Liabilities that may arise from deliveries and services provided to the business: Your multifunctional printer, scanner, and copier needs new toner. You place an order for the toner from your supplier. However, you do not pay the associated invoice straight away. This results in a liability.

2. Liabilities that arise due to taking out a loan: Your multifunctional device is broken beyond repair. You buy a new one and finance its purchase with a bank loan. The loan, also called credit, has a term of five years. This results in liabilities to your credit institution.

3. Liabilities that arise due to paydowns: Initially, you have only made a down payment for the new device. According to the invoice, you are waiting until the due date to pay the full purchase amount—possibly for liquidity reasons.

4. Liabilities that arise due to outstanding tax payments: You have not yet paid the value-added tax (VAT) for your marketing agency, which must regularly be paid to the relevant tax office.

5. Liabilities that arise due to shareholdings in your business: You only have limited partners involved in your marketing agency, and you still owe them a share of last year’s profits. This results in liabilities to these partners.

Liabilities can also arise when you issue bonds as a business. You incur liabilities to those who buy the bonds. A bond is a financial tool used to raise funds: as a business, you borrow funds from the capital market for a certain period of time. The investors provide a certain amount of capital (i.e., a loan) to the business that is issuing the bonds. As a bond purchaser, you become a creditor. As an issuer, you become a debtor.

What are short-term and long-term liabilities?

There is a clear distinction between short-term and long-term liabilities.

Examples of short-term liabilities include:

• Overdrafts: These are loans with an agreed credit limit that the bank grants the business for a current account. The account may be overdrawn up to the agreed limit.
  
• Deliveries and services: Liabilities resulting from deliveries and services provided to the business are also considered short term. See example 1 above.
  
• Paydowns: These are also short-term liabilities. See example 3 above.
  
• Taxes and social security contributions: These are also considered short-term liabilities. See example 4 above.
  

Examples of long-term liabilities include:

• Bonds (debt securities with a fixed interest rate): These are long-term liabilities. See example 5 above.
  
• Loans (credits with a term of at least one year): Loans also fall into this category. See example 2 above.
  
• Mortgages: Mortgages are an additional example of long-term liabilities.
  

What is the difference between creditors and debtors?

A party that delivers something is called a creditor. Creditors make their services available to debtors in the form of goods, money, or working time. The debtors owe the creditors the agreed compensation for their services.

These terms are primarily used when discussing “forward purchases.” This term refers to purchases with a fixed payment date or payment period. The moment the invoice date and payment date differ, the concept of creditors and debtors becomes relevant: should a business fail to pay an invoice for a delivery immediately, this creates a so-called “open item.” At this point, the business owes the outstanding invoice to its supplier. As a result, the business becomes a debtor. From an accounting perspective, this transaction can also be described as follows: the supplier grants the business a supplier credit. This is why suppliers are also referred to as creditors.

The flow of goods and invoices from the suppliers to the business and customers

The term “liabilities” and its counterpart, “receivables,” can describe the flow of goods and invoices on a business’s balance sheet. These appear as follows:

Supplier → Goods/Invoice → Business → Goods/Invoice → Customers

Creditor → Liabilities → Business → Receivables → Debtor

In this flowchart, liabilities represent:

• What the business owes to other parties: These are liabilities arising from trade payables that the business owes to its suppliers.
  
• What other parties owe the business: These are outstanding receivables from deliveries and services that customers owe to the business. Therefore, receivables are the counterpart of liabilities; receivables refer to legal claims for payments, goods, or services that a business claims from a debtor.
  

When finalizing a contract, both parties—the creditors and the debtors—take a certain risk:

• For creditors: There is a risk that the debtors cannot meet their outstanding obligations.
  
• For debtors: There is a risk that the business is unable to make its payments and becomes insolvent.
  

What is the difference between liabilities and provisions?

Liabilities differ from provisions, since a liability’s payment date or period, and payment amount, is known. Provisions, on the other hand, are generated for future losses or expenses that remain uncertain at the time the accounts were drafted.

Provisions are not reserves

Provisions are part of debt capital. For this reason, provisions are not the same as reserves. Provisions are accounted for as expenses and result in reduced profits. Reserves, on the other hand, are tied-up equity. They are withheld from the business’s profits and increase equity.

Provisions example

Let’s say an agency head employs an entire team and offers each team member a pension plan. As a result, the agency head must create a provision for uncertain liabilities. This also includes the pension provisions for their employees. When preparing the accounts, the agency head can neither quantify the payment amount nor determine its due date. Therefore, the provisions are valued in accordance with actuarial principles.

For more information on all things accounting, visit the Stripe More resources portal. You can also use Stripe Revenue Recognition to optimize your accrual accounting, making your account processes quick and accurate. To discuss how Stripe can support you with your financial processes, contact our sales team.