One of the fundamental principles in accounting is the concept of a ‘Normal Balance‘. Whether you’re an entrepreneur or a seasoned business owner, understanding the normal balance of accounts is crucial to keeping your business’s financial health in check.
What is a normal balance?
In accounting, ‘Normal Balance’ doesn’t refer to a state of equilibrium or a mid-point between extremes. Instead, it signifies whether an increase in a particular account is recorded as a debit or a credit. A ‘debit’ entry is typically made on the left side of an account, while a ‘credit’ entry is recorded on the right.
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The five types of accounts and their normal balances
There are five types of accounts in accounting: assets, liabilities, equity, revenue, and expenses. Each of these has a ‘normal balance’. Let’s look at them one by one.
1. Assets
An asset is anything a company owns that holds monetary value. Cash, equipment, and inventory are all examples of assets. Assets have a normal debit balance. This means that when you increase an asset account, you make a debit entry. For instance, when a business buys a piece of equipment, it would debit the Equipment account.
Asset Account (e.g., Equipment) Debit (Increase) Credit (Decrease) Purchase of Equipment $5,000
2. Liabilities
Liabilities represent what a company owes to others. This includes things like loans and accounts payable. Liabilities have a normal credit balance. So, if a company takes out a loan, it would credit the Loan Payable account.
Liability Account (e.g., Loan Payable) Debit (Decrease) Credit (Increase) New Loan Taken $10,000
3. Equity
Equity signifies the ownership interest in the company. It’s essentially what’s left over when you subtract liabilities from assets. When owners invest more into the business, you credit the equity account, hence, it has a normal credit balance.
Equity Account (e.g., Owner’s Capital) Debit (Decrease) Credit (Increase) Owner’s Investment $20,000
4. Revenue
Revenue is the income that a company earns from its business activities, typically from the sale of goods and services to customers. Revenue accounts have a normal credit balance. When a company makes a sale, it credits the Revenue account.
Revenue Account (e.g., Sales Revenue) Debit (Decrease) Credit (Increase) Sales Made $15,000
5. Expenses
Expenses are the costs a company incurs to generate revenue. Examples include rent, salaries, and utilities. Expense accounts have a normal debit balance. If a company pays rent, it would debit the Rent Expense account.
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Expense Account (e.g., Rent Expense) Debit (Increase) Credit (Decrease) Rent Paid $2,000
Understanding the normal balance of accounts
In accounting, understanding the normal balance of accounts is crucial to accurately record financial transactions and maintain a balanced ledger. The normal balance can either be a debit or a credit, depending on the type of account in question. It is the side of the account – debit or credit – where an increase in the account is recorded.
T-account model
A T-account is a visual representation of an account that looks like a ‘T’. The horizontal line at the top represents the name of the account. The vertical line in the middle separates the two sides: the left side is for recording debits, and the right side is for recording credits.
For example, for an asset account like Cash, increases are recorded on the debit side, and decreases are recorded on the credit side, following the rule of normal balances where asset accounts have a debit normal balance.
Debits vs credits
In accounting, debits and credits are the fundamental building blocks in a double-entry accounting system. Depending on the account type, an increase or decrease can either be a debit or a credit. Understanding the difference between debit and credit is needed.
- For asset and expense accounts, debits increase the balance and credits decrease the balance.
- For liability, equity, and revenue accounts, credits increase the balance and debits decrease the balance.
Understanding the nature of each account type and its normal balance is key to knowing whether to debit or credit the account in a transaction.
For example, if you debit an asset account, such as cash, you increase its value. On the other hand, debiting a liability account, such as accounts payable, would decrease its value. The opposite applies for credits.
Here’s a simple table to illustrate how a double-entry accounting system might work with normal balances.
Consider a scenario where a business purchases $5,000 of equipment by taking a loan and then earns $2,000 in revenue.
Date Account Name Type of Account Debit (Dr.) Credit (Cr.) 01/06/2023 Equipment Asset 5,000 01/06/2023 Loan Payable Liability 5,000 10/06/2023 Sales Revenue Revenue 2,000 10/06/2023 Cash Asset 2,000
In this table:
- On June 1, 2023, the Equipment account is debited (increased), reflecting the acquisition of new assets. At the same time, the Loan Payable account is credited (increased), showing that the business has taken on new debt.
- On June 10, 2023, the Sales Revenue account is credited (increased) when the business earns revenue, and the Cash account is debited (increased) to reflect the cash inflow from the revenue.
This way, the transactions are organized by the date on which they occurred, providing a clear timeline of the company’s financial activities.
The equation
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At the heart of accounting lies the basic accounting equation: Assets = Liabilities + Equity. This equation must always stay in balance and forms the basis of the double-entry accounting system.
A practical example of normal balance
Let’s consider a simple scenario that illustrates the concept of normal balance using two accounts: Cash (an asset account) and Equipment (another asset account).
Let’s say you start a small business with $10,000 in cash. As per the normal balance rule, the Cash account (an asset account) increases by debits. Therefore, you would record this transaction as:
Account Debit (Increase) Credit (Increase) Cash $10,000
Next, you decide to purchase some equipment worth $2,000 using the cash from your business. This transaction affects two accounts: Cash and Equipment. You are reducing your cash, which, as an asset account with a normal debit balance, would be recorded as a credit. Simultaneously, you are increasing your equipment, which is also an asset account with a normal debit balance, and this would be recorded as a debit.
Account Debit (Increase) Credit (Decrease) Equipment $2,000 Cash $2,000
After these transactions, your Cash account has a balance of $8,000 ($10,000 – $2,000), and your Equipment account has a balance of $2,000.
By understanding the normal balance concept, you can correctly record transactions, such as the cash injection and the equipment purchase, in your double-entry bookkeeping system. Remember, the normal balance is the side (debit or credit) that increases the account. For asset accounts, such as Cash and Equipment, debits increase the account and credits decrease the account.
Normal balances of accounts chart
Here’s a summary of the accounts chart that illustrates the normal balance of various types of accounts:
Type of Account Normal Balance Increase Decrease Assets Debit Debit Credit Liabilities Credit Credit Debit Equity Credit Credit Debit Revenue Credit Credit Debit Expenses Debit Debit Credit Dividends (or Draws) Debit Debit Credit
This chart is useful as a quick reference to determine whether an increase or decrease in a particular type of account should be recorded as a debit or a credit.
Remember, in the context of double-entry bookkeeping, every transaction involves at least two accounts, with debits equal to credits. This mechanism keeps the accounting equation (Assets = Liabilities + Equity) in balance at all times.
The impact of understanding normal balances
Knowing the normal balances of accounts is pivotal for recording transactions correctly. It aids in maintaining accurate financial records and statements that mirror the true financial position of your business. Misunderstanding normal balances could lead to errors in your accounting records, which could misrepresent your business’s financial health and misinform decision-making.
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Source: https://t-tees.com
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