The financial statements of a business which report its profitability and financial position primarily consist of a profit and loss account and a balance sheet. Accounts recorded in these financial statements fall in either of the four categories i.e., revenue or expense and assets or liabilities. Revenues and assets are represented by current or future inflows whereas expenses and liabilities by current or future outflows.
The article “expense vs liability” looks at meaning of and differences between two of these components – expense and liability.
Definitions and meanings
An expense is a cost that must be incurred by an entity so as to generate business revenue. In the course of their revenue generating activities, business entities would acquire some goods or utilize some services and the monetary outflow expended on them are the expenses of the entity. For example, a manufacturing entity would be required to pay rent to the owner of its factory building and wages to its workers so as to carry on its production activities. These payments qualify as business expenses.
Expenses incurred in business can be broadly categorized based on the stage of the business at which they are incurred:
- Manufacturing expenses: Expenses incurred in the manufacturing process such as direct materials, worker wages, power and oil, supervisor salaries, factory rent etc.
- Selling and distribution expenses: Expenses incurred in the process of selling goods such as transport costs, handling costs, packaging costs, warehouse costs, advertising costs etc.
- Administrative expenses: Expenses incurred in day to day routine operations such as printing and stationery, office electricity, telephone and internet expenses etc.
- Finance expenses: Expenses incurred to meet funding requirements primarily loan processing fees and interest on loans
Expenses are accounted for by charging them to trading or profit and loss account with a credit to some payable account (rent payable, salary payable, interest payable etc.) in case of accruals and bank account in case of cash expenses.
Journal entry for expenses
Mr. A is engaged in the business of providing legal services to corporate clients. During this process, he has hired two lawyers to assist him in all of his paperwork. Each is paid $1,000 as monthly salary. Additionally, he also pays an office rent of $500 on monthly basis. These qualify as expenses and the entry accounted for is:
Salaries a/c…..2,000 [Dr]
Rent a/c…..500 [Dr]
Bank a/c…..2,500 [Cr]
(Being salaries and rent for the month accounted and paid via check)
A liability is a financial obligation of an entity that has arisen as a result of its past business transaction. When an entity purchases any goods or avails any services, it is obligated to compensate the seller usually by way of a monetary payment. Similarly, when an entity borrows money from a lender, it is obligated to pay interest on the loan as well as repay the principal amount of loan. The obligations like these become liabilities for the purpose of entity’s financial statements. Liabilities are typically classified into:
- Current liabilities: Obligations that are required to be settled within a short period typically within a year; for example, creditors with a credit period of 90 days short term notes payable etc.
- Non-current liabilities: Obligations that do not require short-term settlement and that continue for several years over a long term; for example, bank loans and debentures issued by the entity.
Journal entry for liabilities
Continuing the same example as above. Assuming Mr. A does not make the payment of rent immediately but his landlord allows him a period of 2 months to make the payment. In such case when the expense is recorded, a liability amounting to $500 will be created in favor of the landlord.
Lender’s a/c…..500 [Cr]
(Being – rent for the month accounted for)
Additionally, if Mr. A takes a loan of $50,000 to renovate his office, he will need to create a liability in his books in favor of the lender:
Bank a/c…..50,000 [Dr]
Loan a/c…..50,000 [Cr]
(Being loan availed for renovation of office)
When the loan is ultimately paid back, the liability account will be extinguished from the books.
Difference between expense and liability
The seven key points of difference between expense and liability have been detailed below:
1. Basic meaning:
- An expense is a cost required to be incurred during the course of revenue generating activities of a business.
- A liability is financial obligation of an entity that is created due to a business transaction conducted in the past.
2. Type of account:
- An expense is a nominal account in nature.
- A liability is a personal account in nature as it is created in favor of a person or entity. A bank loan, for example, is a liability in favor of a bank, a liability for purchase of goods or materials is created in favor of the vendor.
3. Recording in books of accounts:
- Expenses are recorded on the debit side of the trading or profit and loss account and cause a reduction in entity’s net profit.
- Liabilities are recorded in the balance sheet on liabilities side.
4. Consequences of non-settlement:
- If expenses are not settled at the time of incurrence, it results in creation of a liability.
- If liabilities are not settled on due date, it can give rise to legal consequences for the entity especially in case of default of bank loans, public deposits and large creditors etc.
5. Carried forwards across accounting periods:
- Expenses are recorded only in the period in which they are incurred. They are absorbed by the profit or loss for the period to which they belong and thus not carried forward in subsequent accounting periods.
- Liabilities, on the other hand, are carried forward in the balance sheet and continue to reflect in the books till they are settled or written back.
6. Monetary outflow:
- Not all expenses result in a monetary cash outflow for the business. For example, non-cash expenses such as depreciation do not result in monetary outflow but cause reduction in the value of an asset.
- Liabilities however would always result in monetary outflow to settle them (unless they are written back).
- Expenses include raw materials, wages and salaries, electricity, transport expenses, advertising expenses etc.
- Liabilities include creditors for goods, loans and deposits outstanding, outstanding debentures etc.
Conclusion – expense vs liability
Both expenses and liabilities tend to create a monetary obligation for any entity. In fact, expenses and liabilities have a dependent relation with each other. For example, accruing of several expenses lead to creation of liabilities with respect to payables. On the other hand, taking on liabilities may result in incurrence of subsequent expenses such as taking of a loan will result in accrual of interest to service the loan liability. In either case, recording of these expenses and liabilities appropriately is important as they impact profitability as well as financial position of the entity.