What Is the Normal Balance of a Liability?
Master the foundational principles of accounting by understanding how liability accounts are properly recorded and managed.
Financial record-keeping is a fundamental process for any business, serving as the backbone for understanding its economic activities. It involves systematically tracking all financial events, from everyday transactions to larger investments and obligations. This recording provides a clear picture of a business’s financial health. By organizing this information, businesses can make informed decisions, manage resources, and comply with reporting requirements.
Understanding Normal Balance
In accounting, every financial transaction impacts at least two accounts, a concept known as double-entry bookkeeping. For each transaction, one account receives a “debit” entry and another receives a “credit” entry, ensuring the accounting equation remains balanced. A “normal balance” refers to the side of an account (debit or credit) where increases are recorded. For instance, debits increase asset and expense accounts, while credits increase liability, equity, and revenue accounts.
The five main types of accounts are Assets, Liabilities, Equity, Revenues, and Expenses. Assets, representing what a company owns, have a normal debit balance, meaning a debit increases their value. Conversely, Liabilities and Equity, representing what a company owes and the owners’ stake, normally have a credit balance, increasing with a credit entry. Revenue accounts, reflecting income earned, also have a normal credit balance, while Expense accounts, detailing costs incurred, have a normal debit balance.
Normal Balance of Liability Accounts
Liability accounts represent a business’s financial obligations to external parties. These obligations can range from short-term debts due within a year to long-term commitments extending over several years. Because liabilities signify an amount owed, an increase is recorded as a credit.
This treatment aligns with the fundamental accounting equation: Assets = Liabilities + Equity. In this equation, liabilities are on the right side, similar to how credits are recorded on the right side of an account. Common examples of liability accounts include Accounts Payable, amounts owed to suppliers for goods or services purchased on credit, and Notes Payable, formal written promises to pay a specific amount by a future date. Unearned Revenue, representing payments received for goods or services yet to be delivered, and Salaries Payable, for wages owed to employees, are also liabilities. A decrease in a liability account, such as when a debt is paid off, is recorded as a debit.
Recording Liability Transactions
When a business engages in financial activities that affect its liabilities, these changes are captured through journal entries. These entries reflect the double-entry system, where every transaction has a corresponding debit and credit. For instance, if a business borrows funds by taking out a loan, its cash (an asset) and Notes Payable (a liability) both increase. This transaction would be recorded by debiting Cash and crediting Notes Payable.
Consider the scenario where a business purchases supplies on credit. The Supplies account (an asset) would be debited to reflect the increase in supplies, and the Accounts Payable account (a liability) would be credited, indicating the obligation to pay the supplier. When the business later pays this bill, Accounts Payable is debited to decrease the liability, and Cash is credited. Similarly, if a company receives an upfront payment for services not yet rendered, Cash (an asset) is debited, and Unearned Revenue (a liability) is credited. As services are provided, Unearned Revenue is reduced with a debit, and a Revenue account is credited to recognize earned income.