Expense or Liability?

As a new business owner learning to manage your business's accounting records, you may soon find figuring out whether something you are paying for should be recorded as an expense or a liability can get confusing.

Both are money that your business needs to pay out to continue operating. But how do you differentiate between the two?

Three Features of Expenses

First, you should know that your expenses are tied to your revenue. You will have to pay for these for your business to make money. So, they are operational costs.

The second thing you need to know is that expenses will appear on your income statement rather than your balance sheet. This point is critical to remember when preparing your company's financials.

Lastly, you need to know that you can pay expenses immediately with cash or delay the payment for a period in the future. When you do this, the expense remains but also becomes a liability.

A Simplified Example

Let's say you make chocolate bananas for sale. To make money, you need to buy the oil, chocolate, and bananas and pay for the electricity and gas to make them.

You pay for these things every time you use them. All these expenses are used to generate revenue for your business. They are expenses.

But then, one day, the shopkeeper tells you that you can buy the banana today but pay her for it next month. So you agree.

How is this Recorded?

When you go to do your accounting, you will still record the expense of the ingredients you used to make the choco-banana. In accounting, expenses are recorded on the debit side of your accounts.

So, to complete the transaction, you need to enter a credit.

If you had paid with cash, you would credit cash. Since cash is an asset, this credit entry would decrease the cash you have as a business.

But now that you have agreed to pay next month, you will record it under your accounts payable account (which is just fancy accounting terms for money you owe others.)

Since Accounts Payable is a liability, you will increase it by recording a credit to it, thus completing your entry on both the debit and credit sides.

Your expense remains an expense but has now been recorded as a liability.

The Challenge

Challenge yourself to list your expenses and identify the ones that become liabilities to help you grasp the idea better.