LIABILITIES (third component of the Balance Sheet)

Thus far we have discussed the first two components of the Balance Sheet, namely the Heading and the Assets. The third component of the balance sheet is known as Liabilities. Liabilities are those items a business owes to other businesses, governments, shareholders, employees, and so on. Think of liabilities as items placing an economic burden onto a company. Examples of liabilities include accounts payable, taxes payable, interest payable, wages payable, bank loan payable, property taxes payable, and mortgage payable.

Like Assets, Liabilities are broken down into two classifications;

Current Liabilities are liabilities that are due in a short period of time; - usually within one year or less. Long-term Liabilities, on the other hand, are liabilities that require payment beyond a company's operating cycle (ie longer than one year). Lets look at both classification of liabilities and examine examples of each.

Current Liabilities:
As mentioned above, current liabilities are items a company owes that must be paid within one year. Examples of current liabilities would include; accounts payable, wages payable, property taxes payable, insurance payable, interest payable, notes payable, taxes payable, utilities payable, short-term bank loan payable and so on. The Toy Company's Current Liabilities on its Balance Sheet as of December 31, 200X are as follows;

Let's look at each of The Toy Company's current liabilities; beginning with Accounts Payable.

Accounts Payable
An account payable is a short-term liability a company incurs when it purchases items on credit. Furthermore, many businesses buy inventory, offices supplies, office equipment, store supplies, etc. and elect to pay for them at a later date. As of December 31, 200X, the Toy Company still owes $12,254 for office supplies, equipment, store supplies, inventory, and so on. As the company pays for these items, the account balance ($12,254) will decrease. Also, when the company purchases more items on credit, the accounts payable increases.

Accounts payable are considered current liabilities because payment is usually due in less than one year. Further, a company offering credit will usually request payment within 30, 60, or 90 days from the date of payment.

Income Taxes Payable
The second current liability shown on The Toy Company's balance sheet is income tax payable. Businesses, like individuals, must pay taxes on the income they make. The amount of income tax obligation a business is responsible for depends upon several factors. Four important factors include;

1. Whether the business is a sole-proprietorship, partnership or corporation. Sole proprietorships and partnerships are generally taxed at the same rate as individuals (non business owners). Corporations have their own tax rates and rules.

2. The amount of income made by the business. Established tax rates or percentages have been created for income levels for geographic areas. A tax percentage is multiplied by a company's Net Income Before Taxes to arrive a businesses' income tax obligation.

3. State/provincial tax rate applied to taxable income. Each state and province has their own state/provincial tax rate or percentages. Therefore, before a business can calculate its tax obligation, it must first know the state/provincial tax rates at the various income levels.

4. Whether tax credits are available to the business. Some states and federal governments will provide tax credit to companies to encourage more business start-up. Business tax credits will ultimately reduce the amount of tax a company pays.

Income tax is an extremely specialized field and should be left to professionals. If you are an existing business owner, chances are you already have an accountant preparing your tax returns. If however, you are planning to open a business and preparing your financial forecasted statements, it would be wise to contact an accountant. The accountant will be able to tell you the tax rates, at different levels of income, for your particular state/province and country. Now lets return to our Toy Company example. The following assumption applies to our example.

"The Net Income before taxes for the Toy Company in 200X (from January 1 to December 31) is $14,190. Donald's accountant determined a tax rate of 40% would apply to the net income before tax. Therefore, the income taxes to be paid will be $5,676 ($14,190 x 40% = $5,676). As of December 31, 200X, the tax obligation has not been paid and therefore is considered income taxes payable".

Remember that Net Income Before Taxes must be calculated before a business can determine its income tax obligation. Net Income Before Taxes is a calculated by subtracting business expenses from business revenues. After the Net Income Before Taxes have been calculated, an accountant will apply a percentage(s) to this amount to arrive at your tax obligation. Moreover, The Toy Company's Net Income Before Taxes (Revenue - Expenses) was $14,190. The accountant applied a rate of 40% to arrive at The Toy Company's tax obligation. In other words, the company is obligated to pay $5,676 in income tax ($14,190 x 40% = $5,676). Since the company didn't pay the income tax as of December 31, it's considered a payable. When the company pays the tax, the income tax payable account will be reduced to zero. For more information on how to calculate net income before taxes, refer to the Income Statement.

Income tax payable will always be considered a current liability since payment is due in less than one year. The Toy Company will most likely pay the $5,676 tax obligation before April 30, 200Y. Depending on where you live, laws are in place that require businesses to pay income tax on an installment basis. Be sure you discuss this matter as well as other tax issues with an accountant.

Short-Term Loan Payable
Short-term loans that require payment in less than one year are classified into an account called Short-Term Loan Payable. For example, on August 10, 200X The Toy Company received a $7,000 short-term loan (1 year) from a local bank. The loan is considered a current liability because it's due in less than one year. The company is required to make monthly payments on the loan until it's fully paid on July 30, 200Y. As of December 31, 200X the outstanding balance owed on the loan is $5,179 (see balance sheet above). This means that from August to December, 200X, the company paid $1,821 on the loan ($7,000 - $5179).

Long-Term Liabilities:
The second classification of business liability is called Long-Term Liability. As mentioned earlier, a long-term liability is money owed by a business that must be paid beyond a company's operating cycle. In other words, it is debt that is due beyond a one year period. To put liabilities into perspective we can say;

Current liabilities are debts that must be paid in one year or less,
while long term liabilities are debts that must be paid sometime beyond one year.

Examples of long term liabilities include; a 3 year business bank loan, a 5 year business car loan, a mortgage on a corporate building, a 2 year loan from a family members who invests into your company, and the list goes on and on. Think of a mortgage on your house for a moment. Your house mortgage is a long-term liability to you personally - not your business. Therefore, the balance sheet for your business would not include your house mortgage as a long term liability. In other words, personal items are personal items and business items are business items; they are considered to be separate entities.

The Toy Company's Long-Term Liabilities on its Balance Sheet as of December 31, 200X are as follows;

Mortgage on Building
Recall under the assumption section of our example, the following;

"On July 1, 200X, The Toy Company received a 10 year, $22,500 loan. The loan was needed to purchase a building. The building will be used to sell the company's preassembled toys".

The $22,500 dollars is a loan the company must pay back to the bank. All loans are considered liabilities and since the loan is payable over 10 years, it is considered a long term liability. On December 31, 200X the balance owning on the Mortgage is $19,757. As you can see, the loan has reduced from $22,500 down to $19,757 in half of one year (July to December, 200X). This reduction represents the amount of principal the company paid on the loan. Therefore, it's safe to say the Toy Company paid $2,743 in principal payments ($22,500 - $19,757).

Total Liabilities
Total Liabilities represent the sum of all Current Liabilities plus the sum of all Long Term Liabilities. Simply stated Total Current Liabilities plus (+) Total Long-Term Liabilities = Total Liabilities ($23,109 + $19,757 = $42,866). Below depicts the Liabilities of the Toy Company as of December 31, 200X.

As of December 31, 200X, The Toy Company owes $42,866 dollars to other businesses (banks, governments and other businesses). $23,109 is required to be fully paid within one business year (short-term liabilities), while $19,757 is required to be paid later than one year (long-term liabilities). This concludes the Liabilities section of the Balance Sheet. The next component of the balance sheet is called the Equity section.