Debits and Credits Part Two (DEAD CLIC)
Last time we looked at a major source of debit entries: Assets. This time, we shall explore Liabilities, Expenses and Income.
As a quick reminder, this is how the main types of transactions line up as either debit or credit entries:
We also need to remind ourselves of the fundamental accounting equation:
ASSETS = LIABILITIES + OWNER’s EQUITY (CAPITAL)
What are Liabilities?
Liabilities are the opposite of assets. Liabilities are an obligation of the business to transfer economic resource as a result of past events.
An obligation is a duty of responsibility that the entity has no practical ability to avoid. (IFRS Conceptual Framework for Financial Reporting)
In short, a liability is something that a person or an entity owes.
Example
Daviot Foods Ltd purchases an ice cream making machine. The machine is delivered on June 2nd and Daviot agree to pay the sum of £8,000 within 30 days of delivery.
When the transaction is agreed and the machine is delivered, Daviot’s assets increase by £8,000. As we have seen from the last part, this increase in assets is a DEBIT entry.
As payment is yet to be made, a corresponding entry of £8,000 would be made in the trade payables ledger. Trade Payables are a liability and are therefore a CREDIT ENTRY.
The entries for this transaction would be recorded as follows:
Daviot make their payment of the £8,000 on 24 June. At this stage, Daviot’s cash decreases by £8,000. Cash is a type of asset (positive balances are recorded as a debit), so a decrease in cash would be recorded as a CREDIT entry.
Upon payment of the £8,000 – the Liability to pay (recorded in the Trade Payables) is removed. This decrease in Liabilities is recorded as a DEBIT entry, to cancel out the previous credit entry:
Why is Expense a Debit?
An Expense is a Debit because it results in a decrease of Capital (the owner’s equity). We know from the DEADCLIC acronym that Capital is a credit entry, so a decrease in capital must be a debit.
When I was learning debits and credits, it seemed expenses should be debits, the same as assets are. Although it seems counter-intuitive, It can be explained using the fundamental accounting formula:
ASSETS = LIABILITIES + CAPITAL (OWNER’s EQUITY)
Let’s assume that a new business has just one asset: £5,000 in cash. This business also has no liabilities, so using the accounting formula, we see that Capital must be £5,000.
ASSETS = LIABILITIES + CAPITAL (OWNER’s EQUITY)
£5,000 = £0 + Capital (Owner’s Equity)
Capital (Owner’s Equity) = £5,000
Now let us suppose that the business pays £400 to set up a limited company. This £400 payment is an Expense. The assets of the business have decreased to £4,600. The business does not have any extra assets or liabilities as a result of its expense, so the accounting formula would be:
ASSETS = LIABILITIES + CAPITAL (OWNER’s EQUITY)
£4,600 = £0 + Capital (Owner’s Equity)
Capital (Owner’s Equity) = £4,600
We can see that the £400 expense has lead to a £400 decrease in Capital. A decrease in Capital is a debit entry.
In double entry bookkeeping, this transaction would be recorded as:
- A decrease in Cash (credit entry)
- An increase in Administration Expenses account (debit entry)
Why is Income a Credit?
Income is a credit because it increases the amount of Owner’s Equity (Capital).
Example 1
Diane, the owner of Go Go Promos is paid £600 for handing out flyers for a concert that Funkytown Ltd is putting on.
We shall assume that before the transaction Go Go had £4800 in assets, £300 in Liabilities and £4500 in Capital
ASSETS = LIABILITIES + CAPITAL (OWNER’s EQUITY)
£4,800 = £300 + £4,500
When Go Go are paid, their assets increase by £600 (Cash/Bank). Their liabilities remain the same, so there must be a corresponding £600 in Capital to balance the equation.
ASSETS = LIABILITIES + CAPITAL (OWNER’s EQUITY)
£4,800 + £600 = £300 + Capital
Capital = £5,400
This would be recorded as:
DEBIT Cash/Bank £600
CREDIT Income Account £600
The entries in Go Go Promos’ books would be as follows:
When does Income NOT increase Capital?
When the Income is Unearned Income. However, this is still a Credit entry.
Unearned Income is where an entity receives payment in advance for goods and services they have not yet provided. When income is Unearned Income, it is not initially credited to the Income Account, rather it is recorded as a liability because the entity is now under an obligation to provide the goods or services it has already been paid for.
Once the entity fulfils its obligation, the liability is cancelled and the amount is then recorded as actual income.
Example 2
Taking the previous example we shall now assume that Go Go Promos were paid the £600 in advance and have yet to hand out the flyers.
First we look at the Accounting Equation:
ASSETS = LIABILITIES + CAPITAL (OWNER’s EQUITY)
Go Go’s assets have increased by £600, as they have received the payment. This time, as this is unearned income, the liabilities of Go Go Promos increase by £600 instead of its Capital.
£4,800 + £600 = (£300 + £600) + £4,500
£5,400 = £900 + £4,500
The accounting entries for this would be:
DEBIT Cash/Bank £600
CREDIT Unearned income liability £600
Once the work has been completed, the liability is cancelled and recorded as actual income.
DEBIT Unearned Income Liability £600 (removes initial entry)
CREDIT Income Account £600
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