Difference Between Debt and Liabilities

AndreyPopov/iStock/GettyImages

Business debts and liabilities both involve your business owing someone else money. In casual conversation, they're often the same thing; in accounting-speak, they're not completely identical. One difference between debt and liabilities is that all debts are liabilities, but not all liabilities are debt.

TL;DR (Too Long; Didn't Read)

A liability is money your business is obligated to pay because of past events such as, for example, purchases you made or loans you took out. All your business debts are classed as liabilities in your financial statements, but some liabilities, such as unpaid pensions, aren't considered "debt." Instead, they're non-debt liabilities.

Debt vs. Liabilities

A business liability is an obligation of the business derived from past events that will cost money to resolve. For example, if you order a ton of pig iron for your foundry on credit, that order is the past event. The obligation is the amount recorded in accounts payable, which exists until you pay it off.

The obligation is a debt as well as a liability. Most liabilities are considered debts, including long-term liabilities, current or short-term liabilities and contingent liabilities. They're also referred to as long-term debt, contingent debt and short-term debt.

There are some exceptions, however. Unfunded pension obligations and payments that are in arrears are classed as non-debt liabilities.

Short-Term Debt and Liabilities Examples

Short-term liabilities, AKA short-term debts, are bills that are due within the next 12 months. There are many short-term liabilities examples.

  • Accounts payable. Whatever you buy on credit usually has to be paid off fairly soon.
     
  • Accrued liabilities. This account includes the debt you owe for purchases where you haven't received the invoice yet.

  • Interest payable. Interest on your short-term debts.

  • Accrued wages. If you haven't cut your staff their checks for the past week's work yet, that counts as a liability.

  • Customer deposits. Payments made in advance for goods or services.

  • Current portion of debt payable. If you have long-term debts to pay, the current portion is the amount due in the current year.

  • Taxes payable. If necessary, you may have separate journal entries for income taxes, payroll taxes and sales taxes due.  

Long-Term Liabilities

Long-term liabilities and debts are due more than a year from now. Long-term liabilities examples include bonds, mortgages, long-term loans and debentures. Any loan payments due in the next 12 months count as a current liability.

  • Bonds are publicly-traded securities. A company issues bonds as a way to raise money, promising to pay the buyers the purchase price plus interest when the bonds mature.

  • A debenture is a bond with no collateral backing it. Treasury bills are a debenture, for example. As they're riskier than other bonds, only governments or the most reliable, safe corporations issue them.

  • Mortgages are loans backed by real estate or buildings that serve as collateral.

  • Bank loans are long-term liabilities if your business will be carrying some of the debt a year from now.

Contingent Liabilities Examples

Contingent liabilities are different because they're an X-factor. You don't know for sure if you'll owe a debt unless and until some event comes to pass.

The classic contingency liabilities examples are possible payments on warranties and judgments or settlements in a lawsuit. Say someone has filed suit against you, asking $10,000. That's a liability, but you'll only owe it if they win the lawsuit and receive the amount they asked for. This makes accounting for contingent debts more complicated.

  • If the loss is probably going to happen and you have a good idea how much the debt will be, then you have to record it as a liability. 

  • If it's a possibility but not a probability, you should make a note of it in your financial statements, but you don't report the risk as a liability.

  • If it's a long-shot or "remote" risk, you don't have to record it. While this gives unscrupulous businesses a way to fudge their liabilities by downgrading the odds, accounting ethics frown on this. 

Talking About Debt

While debt and liability are often the same thing, one difference between debt and liabilities is that they're often used in different contexts in accounting.

On the balance sheet, for example, the section listing what you owe is referred to as liabilities. However, when accountants and investors discuss your liabilities, they may refer to the total of all your liabilities as your company's debt.

However, accountants may also refer to debt in a much more narrow context: money that's been borrowed and that you'll eventually have to pay back, rather than all the money you owe. In this context, "debt" means loans made to your business and bonds that you'll have to pay off down the road.

Liabilities vs. Expenses

Unlike debt vs. liability, the differences between liabilities and expenses are more sharply defined. If you order new equipment, that's a liability entered in accounts payable and an expense entered in an expense account, but they're still distinct.

An expense is a cost you incur to generate revenue, such as raw materials, labor expenses and overhead. You subtract expenses from your revenue on the income statement to determine your income.

Unpaid costs for labor and raw materials are also liabilities, but you record liabilities on the balance sheet. Subtracted from your assets, they determine business equity – the amount that the owners would divide up if you dissolved the company today. Subtracting liabilities from income doesn't work.

Debt And Equity

Another difference between debt and liabilities is the way they're used in different formulas for calculating the health of a business. With the debt to equity ratio, for instance, "debt" refers to your company's total liabilities. You divide them by the total owner's equity to get a percentage.

Investors and lenders scrutinize the debt/equity ratio closely when deciding if your company is worth putting money into. If debt is low compared to owners' equity, investors know you can pay your debts without weakening the business. If the ratio is too high, you may look like a bad risk.

The ratio isn't a perfect tool, however. If, say, you carry a lot of debt but the payment dates are all off in the distance, your company's not as at risk as it might look.

Secured or Unsecured Debt

Businesses typically acquire short-term debt because buying on credit is common, even in B2B transactions. They take on other liabilities because debt is a standard way to start or grow a business. Along with short-term vs. long-term liabilities, another way to divide up debt is whether it's secured or unsecured.

A secured loan works like a mortgage: you borrow against an asset you own. An unsecured loan has no collateral, so if you default on the debt, the lender has no claim on your property. They can still take you to court to collect, though.

If you go the secured-debt route, you can usually arrange a larger loan at a better interest rate than if the loan is unsecured. If you're a start-up with no credit history, it's also easier to obtain a loan if you offer security. However, there's the obvious risk of losing your assets if you default; you'll need to think carefully about which assets you can lose and survive if a debt goes unpaid.

References

About the Author

Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com