Sorting out the difference between account types is essential to understanding how to account for business transactions. Business owners and accounting staff are expected to be able to quickly discern the nature of transactions. The timing of the cash flows of the transaction is the key, but once the type of account is determined, it may be even more important to figure out what to do with the account and how an analyst will use it.
The principal difference between liability and expense is timing. Expenses are current-period expenditures that do not have future benefit. Liabilities exist when a company has a future obligation related to a benefit already received. When a liability is booked, the company records a liability as a credit and debits an expense account. This puts the expense in the period the future spending will benefit, which is in accordance with the matching principle.
Financial Statement Location
Liability accounts are found on the company's balance sheet and are classified as long-term or short-term based upon the date the liability will come due. Expenses are found on the income statement. Because expenses are recorded in the period to which they relate, there is no need to segregate by time. It is important to note that because liability accounts change balances year over year, these changes also are found on the statement of cash flows (SoCF). Expenses are included in the SoCF as well, but they are not listed explicitly. When net income is adjusted to arrive at cash from operating activities on the statement, expense activity is included.
When analysts interpret financial statements, liabilities and expenses have different meanings. As liabilities represent future obligations, analysts are concerned that the company has the ability to meet these future obligations. This quality is called the solvency of a business. Expenses, in and of themselves, are not viewed as positive or negative; however, analysts may be interested in how the expenses arose. If a company has high levels of sustained expenses compared with revenues, this could be more troubling than a company that has a few larger one-time expenses.
Future Payment Obligations
Not all future payments are classified as liabilities. Future payments that are required by a company, but where the company has not received the benefit, are not recorded in the accounting records, but instead are disclosed in the notes to the financial statements. A common example of this phenomenon is in the accounting for sponsorship agreements. Even though a company may be contractually obligated to sponsor an event for five years, the company will not record a liability up-front for the agreement. The company will only record the liability for the benefit received but not paid.
- "Principles of Financial Accounting"; Larson, et al; 2005