Liabilities: Are They a Debit or a Credit?
Clarify how liabilities are recorded in accounting. Learn the fundamental logic of debits and credits and how they keep your company's finances in balance.
The system of debits and credits serves as the language for recording and reporting a company’s financial activities. For business owners and investors, grasping this system is important for interpreting financial health. This article focuses on liabilities to clarify how they are recorded and managed within the debit and credit framework.
The Foundation of Debits and Credits
The foundation of accounting is the equation: Assets = Liabilities + Equity. This accounting equation must always remain in balance, representing that a company’s resources (assets) are claimed by its creditors (liabilities) or its owners (equity). Every transaction is recorded using a system called double-entry bookkeeping to keep this equation balanced.
In the double-entry system, every transaction affects at least two accounts using debits and credits. A debit is an entry made on the left side of an account’s ledger, while a credit is an entry on the right side. The terms do not imply positive or negative value; they only indicate which side of the ledger the entry is recorded on.
The rule of double-entry bookkeeping is that for any transaction, the total dollar amount of debits must equal the total credits. This ensures the accounting equation remains in balance. How an account is affected by a debit or a credit depends on the type of account—whether it’s an asset, a liability, or an equity account.
The Normal Balance of a Liability Account
Liability accounts have a normal credit balance. This means that a credit entry is used to increase the balance of a liability account, while a debit entry is used to decrease it. This rule relates to the accounting equation, where liabilities and equity are on the right side. Since credits correspond to the right side of a ledger entry, they increase the accounts on the right side of the equation.
The term “normal balance” refers to the side of the account—debit or credit—that records an increase in value for that account type. For instance, asset accounts are on the left side of the equation and thus have a normal debit balance. Because liabilities represent obligations owed to others, they sit on the right side of the equation and carry a normal credit balance.
When a company incurs a new debt, such as taking out a loan or buying goods from a supplier on credit, the corresponding liability account is credited. This credit entry signifies an increase in the company’s obligations.
How Transactions Affect Liabilities
Consider a common business transaction: obtaining a loan from a bank. Suppose a company secures a $20,000 loan. The company’s cash, which is an asset, increases by $20,000. To record this, the Cash account is debited for $20,000, while a new liability called Loans Payable is created.
To reflect this new debt, the Loans Payable account is credited for $20,000. The journal entry shows a debit to Cash and a credit to Loans Payable, keeping the accounting equation in balance. The asset side increases by $20,000, and the liability side increases by the same amount.
Now, imagine the company makes its first loan payment of $1,000, which consists of $800 in principal reduction and $200 in interest expense. To record this payment, the company must decrease its liability. A debit is used to decrease a liability account, so Loans Payable is debited for $800, reducing the outstanding loan balance.
The payment also involves cash leaving the company, so the Cash account is credited for the full $1,000 payment. The remaining $200 is an expense for the cost of borrowing money, and the Interest Expense account is debited for $200. The total debits ($800 to Loans Payable + $200 to Interest Expense) equal the total credit ($1,000 to Cash), and the transaction is balanced.