Bookkeeping – Debits and Credits in Liability Accounts (Lesson 5)
Liability accounts customarily end with credit values.
Success in business requires the help of others. For most businesses this refers to employees and suppliers. Whenever a business commits to purchase time or product and that employee delivers their time or the supplier delivers the product, you owe them money. This is a liability. Therefore, the question is: ‘How do I record the entry for a liability?’
The dual entry system for bookkeeping is designed to track this information with ease. Since payroll is more complex and is covered in several other lessons in the future; this lesson is going to keep this to the purchase of supplies or products you need for business. All purchases are recorded in the ‘Purchases Journal’. Just as described in Lesson 3 about journals, it is simply a chronological log of what you purchase. Remember in the log the entry is recorded with a date, a ‘Split’ column that identifies which particular account the entry will get posted, a description and a debit or credit entry to that account.
When you purchase an item for resale the entry is usually to an inventory account. In Lesson 4 it was explained that asset types of accounts, inventory is an asset account, increase with a debit entry. Since this is some form of amount owed to a third party, all liabilities increase via a credit. Remember, debits and credits are offsetting entries designed to keep the books in balance via the Trial Balance (TB).
Let’s take a look at a simple purchase entry to the books:
Purchases Journal
Date ‘Split Account’ Description DR CR
08/04/15 Inventory 6 Boxes of Widgets $16.03
Accounts Payable ACME Widget Company $16.03
As explained in Lesson 3, the entry must balance. Notice the total for each Debit and Credit column has equal values. Also note that in the accounts payable line there is an indication to ‘WHOM’ the money is owed. When this information is recorded in the respective ledger (account activity log) the accounts payable will indicate that ACME is owed $16.03.
The purchases journal is one of the more active journals in the books of record for a business. Technology uses a vendor log or a purchases entry screen to enter the particular information. Most often the particular supplier is set up to enter the information to correct account for debit purposes. Since the bookkeeper is using a purchase entry screen the credit is automatically posted to the accounts payable.
This seems relatively easy to grasp and understand but now it is time to complicate this a little so you can get a more comprehensive understanding.
Current Liabilities
Liabilities are divided into two subgroups. The first group is referred to as ‘Current Liabilities’ and these are amounts owed and due within one accounting cycle (usually a year). It was stated above that liabilities are amounts owed for products or services. Well, this is not 100% true. Actually, they also include monetary amounts owed for other types of items and include:
- Taxes owed to governmental authorities;
- The financial value of accrued time off and benefits for employees;
- Long term debt owed via loans from financial institutions; AND
- Amounts owed as a loan from investors/owners of the company.
There are others but they involve more advanced principles of accounting which is explained more in my accounting principles section of the website. For now, almost 95% of all small business liabilities relate to the items above: payroll and purchases.
Some of the items are identified as long-term liabilities which mean they are not due in the current accounting cycle but well into the future. For this lesson I’m going to restrict the information to current liabilities. The following is a list in order of priority customarily found in the liabilities section of the balance sheet.
- Current Liabilities
- Accounts Payable
- Credit Cards
- Accrued Payroll
- Taxes
- Unearned Revenue
- Deposits Owed to Others
- Credit Lines/Bank Notes
- Short Term Loans
- Current Portion of Long-Term Debt
Let’s do a quick review to now.
LIABILITY ACCOUNTS CUSTOMARILY CARRY CREDIT BALANCES. DEBITS DECREASE THE AMOUNTS OWED TO 3RD PARTIES BY REDUCING THE OVERALL CREDIT BALANCE. MOST DEBIT ENTRIES ARE PAYMENTS ON THE ACCOUNT. THE MOST COMMON JOURNALS USED WITH LIABILITIES INCLUDE THE PURCHASES JOURNAL AND THE CASH DISBURSEMENTS JOURNAL.
Most new entrepreneurs use their credit card to make purchases and to pay certain bills. Just like vendor purchases most accounting software packages have an entry screen strictly limited to a particular credit card. In this situation, it is a one line entry identifying the particular debit ledger to post the purchase. The credit side of the equation is automatically posted to the credit card selected.
Now for some more advanced issues.
The author has seen this so much he can’t believe it occurs, but it makes sense. Business owners can spend a lot of money over many transactions and accrue debt. Often, they mistakenly do not provide this information to the bookkeeper. What happens is that the balance sheet understates the overall liability position of the business. If the credits for these purchases are not posted to the books, then at the same time the debits do not exist either. Often the debit side of the entry relates to some form of expense or cost of goods sold over on the profit and loss statement. Therefore, what ends up happening is that the income earned for the sale of the respective products and services has insufficient costs to decrease this income to calculate the correct profit earned. The business ends up with a higher profit and the owner thinks he is making money. The truth is that he has failed to post all the expenses.
This is how businesses get into trouble. They falsely believe they are doing better because they fail to enter all the expenses via the purchases journal.
One of the jobs of the bookkeeper is to have a process in place to collect the necessary information to enter all of it into the books of record. The most common culprit for liabilities is a purchase using the personal credit card of the owner. The solution is simple. The owner needs to drop off the purchase tickets or receipts to the bookkeeper every day for entry into the books. A good bookkeeper constantly asks for the receipts. One bookkeeper I knew was the daughter of the owner. She got tired of asking and getting the ‘I’m too busy to do this look’ and just went out to her Dad’s car each day and found the receipts.
Sometimes you have to be creative in how you find the information you need to do your job.
As businesses mature, they begin to cycle through ebbs and flows for cash in the bank account. Liabilities are satisfied by paying them off. When a payment is made a debit is entered into the accounts payable or credit card account and a corresponding credit is posted to the checking account. As the bookkeeper it is your job to constantly monitor the amounts needed for cash to pay liabilities. This is commonly an accountant’s job, but most businesses do not have an accountant and a bookkeeper. As you learn more on this site you will soon read more about how to do this but this lesson is restricted to teaching you that liabilities customarily end in a credit balance; the exact opposite of the asset types of accounts.
Now there will come a time when you overpay a vendor. The most common vendor overpaid is the insurance company. Many business policies require an entire year’s worth of premium. When this happens, you cannot end with a debit balance in a liability account. In accounting we call this a ‘Prepaid Expense’ which is classified as an asset on the balance sheet. One of your accounts up in the current assets section of the balance sheet is called ‘Prepaid Expenses’ and this is where that debit balance is placed. This is the exact opposite of the explanation for having a credit balance in an asset account as described in Lesson 4.
Summary – Liability Accounts
Debits and Credits are merely values assigned to accounts and offset each other in order for the dual entry system to work effectively. In liability types of accounts credit balances are the traditional ending balance. Debit entries are most commonly payments to the creditors. In liability accounts credits increase the balance and debits decrease the balance. For business in general, the goal is to eliminate all liabilities. This is often impossible as more evolved operations purchase volumes of materials and supplies and pay in regular increments (weekly or monthly). Just about every business will have a liability balance which is credit based. ACT ON KNOWLEDGE.
Value Investing
Do you want to learn how to get returns like this?
Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.
There are four key principles used with value investing. Each is required. They are:
- Risk Reduction – Buy only high quality stocks;
- Intrinsic Value – The underlying assets and operations are of good quality and performance;
- Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
- Patience – Allow time to work for the investor.
If you are interested in learning more, go to the Membership Program page under Value Investing section in the header above.
Join the value investing club and learn about value investing and how you can easily acquire similar results with your investment fund. Upon joining, you’ll receive the book Value Investing with Business Ratios, a reference guide used with all the decision models you build. Each member goes through three distinct phases:
- Education – Introduction to value investing along with terminology used are explained. Key principles of value investing are covered via a series of lessons and tutorials.
- Development – Members are taught how pools of investments are developed by first learning about financial metrics and how to read financial statements. The member then uses existing models to grasp the core understanding of developing buy/sell triggers for high quality stocks.
- Sophistication – Most members reach this phase of understanding after about six months. Many members create their own pools of investments and share with others their knowledge. Members are introduced to more sophisticated types of investments and how to use them to reduce risk and improve, via leverage, overall returns for their value investment pools.
Each week, you receive an e-mail with a full update on the pools. Follow along as the Investment Fund grows. Start investing with confidence from what you learn. Create your own fund and over time, accumulate wealth. Joining entitles you to the following:
- Lessons about value investing and the principles involved;
- Free webinars from the author following up the lessons;
- Charts, graphs, tutorials, templates and resources to use when you create your own pool;
- Access to existing pools and their respective data models along with buy/sell triggers;
- Follow along with the investment fund and its weekly updates;
- White papers addressing financial principles and proper interpretation methods; AND
- Some simple good advice.