Accounting Solver

UNDERSTANDING ACCOUNTING TALK 11: Unwise Use of Debt

by ren on September 16th, 2007

As in the Assets portion of a Balance Sheet where the accounts are categorized into Current and Noncurrent, Liabilities have similar categories. However, it is often the case that the accounts are not categorized but listed all together.

Liabilities are used by a corporation, a proprietorship or small business, or by an individual or household as a means for acquiring assets or meeting expenses which are beyond the capability of the existing Equity. When a liability is incurred, it is expected to be paid or retired from earnings (or income or revenues).

When a liability has to be paid (e.g., a promissory note falling due or a supplier collecting for goods already supplied or services already rendered) and there are not enough earnings after expenses, then another liability is incurred to pay the existing liability.

This is a very expensive way of meeting a liability and is to be avoided or to be utilized only as a last recourse. On top of the interest already incurred on the first liability, additional interest will be incurred from the second liability. This is almost always a sure sign that the corporation or small business or proprietorship is not adequately capitalized or does not have enough Equity.

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POSTED IN: Accounting Concepts, Accounting for NonAccountants, Equity / Capital, Liabilities